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Accounting for Inventories
Inventories in the Crystal Ball
Policy makers, economists, and investors all want to know where the economy is headed. For example, if the economy is headed for a slow-down, it might be prudent on the part of the Federal Reserve to cut interest rates or for Congress to consider a tax cut to head off an economic downturn. Information on inventories is a key input into various decision makers' economic prediction models. For example, every month the U.S. Commerce Department reports data on inventory levels and sales. As shown in the table below, in a recent month these data indicated an increasing level of inventories.
November Inventory and Sales
After studying this chapter, you should be able to: 1 N 2 N 3 N 4 N 5 N 6 N 7 N 8 N 9 N 10 N Identify major classifications of inventory. Distinguish between perpetual and periodic inventory systems. Identify the items that should be included as inventory cost. Describe and compare the cost flow assumptions used in accounting for inventories. Explain the significance and use of a LIFO reserve. Explain the effect of LIFO liquidations. Explain the dollar-value LIFO method. Identify the major advantages and disadvantages of LIFO. Explain and apply the lower of cost or market rule. Explain how inventory is reported and analyzed.
(billions of dollars, seasonally adjusted)
Total business inventories Total business sales Inventory/Sales ratio 1999 $1,145 $ 862 1.33 2000 $1,221 $ 896 1.36 Percent Change 6.64% 3.94%
More importantly, not only were inventories rising, but they were rising at a faster rate than sales. These data raised some warnings about future economic growth, because rising inventory levels relative to sales indicate that consumers are trimming spending faster than companies can slow production.1 These data also raised warning flags for investors in individual companies. As one analyst remarked, "When inventory grows faster than sales, profits drop." That is, when companies face slowing sales and growing inventory, then markdowns in prices are usually not far behind. These markdowns, in turn, lead to lower sales revenue and income, as profit margins on sales are squeezed.2 Research supporting these observations has found that increases in retailers' inventory translate into lower prices and lower net income.3 Interestingly, the same research found that for manufacturers, only increases in finished goods inventory lead to future profit decline. Increases in raw materials and work-in-process inventories provide a signal that the company is building its inventory to meet increased demand, and therefore future sales and income will be higher. These research results reinforce the usefulness of the GAAP requirement that a manufacturer's inventory components should be disclosed on the balance sheet or in related notes.
N. Kulish, "Business Inventories Rose for November, Possibly Adding Evidence of Slowdown," Wall Street Journal, Interactive Edition (January 17, 2001).
S. Pulliam, "Heard on the Street," Wall Street Journal (May 21, 1997), p. C1.
Victor Bernard and J. Noel, "Do Inventory Disclosures Predict Sales and Earnings?" Journal of Accounting, Auditing, and Finance (March 1991), pp. 145182.
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Chapter 8 Accounting for Preview ofInventories Chapter 8 As indicated in the opening story, information on inventories and changes in inventory is relevant to predicting financial performance. The purpose of this chapter is to discuss the basic issues related to accounting and reporting for the costs of inventory. The content and organization of the chapter are as follows.
ACCOUNTING FOR INVENTORIES
Inventory Classification and Systems · Classification · Inventory systems
Issues in Inventory Valuation · Goods included in inventory · Costs included in inventory · Cost flow assumptions
LIFO: Special Issues · LIFO reserve · LIFO liquidation · Dollar-value LIFO · Comparison of LIFO approaches · Basis for selection
Lower of Cost or Market · Ceiling and floor · How LCM works · Application of LCM · Evaluation of rule
Presentation and Analysis · Presentation of inventories · Analysis of inventories
Inventory Classification and Systems
1 Identify major
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classifications of inventory.
Additional Inventory Disclosures
Inventories are asset items held for sale in the ordinary course of business or goods that will be used or consumed in the production of goods to be sold. The description and measurement of inventory require careful attention because the investment in inventories is frequently the largest current asset of merchandising (retail) and manufacturing businesses. A merchandising concern, such as Wal-Mart, ordinarily purchases its merchandise in a form ready for sale. It reports the cost assigned to unsold units left on hand as merchandise inventory. Only one inventory account, Merchandise Inventory, appears in the financial statements. Manufacturing concerns, on the other hand, produce goods to be sold to the merchandising firms. Many of the largest U.S. businesses are manufacturers--Boeing, IBM, Exxon Mobil, Procter & Gamble, Ford, Motorola, to name only a few. Although the products they produce may be quite different, manufacturers normally have three inventory accounts--Raw Materials, Work in Process, and Finished Goods. The cost assigned to goods and materials on hand but not yet placed into production is reported as raw materials inventory. Raw materials include the wood to make a baseball bat or the steel to make a car. These materials ultimately can be traced directly to the end product. At any point in a continuous production process some units are not completely processed. The cost of the raw material on which production has been started but not completed, plus the direct labor cost applied specifically to this material and a ratable share of manufacturing overhead costs, constitute the work in process inventory. The costs identified with the completed but unsold units on hand at the end of the fiscal period are reported as finished goods inventory. The current assets sections presented in Illustration 8-1 contrast the financial statement presentation of inventories of
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Inventory Classification and Systems N a merchandising company and those of a manufacturing company. The remainder of the balance sheet is essentially similar for the two types of companies.
Merchandising Company WAL-MART Balance Sheet January 31, 2000 Current assets (in millions) Cash and cash equivalents Receivables Inventories at LIFO cost Prepaid expenses and other Total current assets
Manufacturing Company ADOLPH COORS COMPANY Balance Sheet December 26, 1999 Current assets (in millions) Cash and cash equivalents Short-term investments Accounts and notes receivable (net) Inventories Finished In process Raw materials Packaging materials Total inventories Prepaid expenses and other Total current assets
$ 1,856 1,341 19,793 1,366 $24,356
$164 113 160 $44 19 34 10 107 69 $613
Whether a company is involved in manufacturing or merchandising, an accurate accounting system with up-to-date records is essential. Sales and customers may be lost if products ordered by customers are not available in the desired style, quality, and quantity. Also, businesses must monitor inventory levels carefully to limit the financing costs of carrying large amounts of inventory. Companies use one of two types of systems for maintaining accurate inventory records--the perpetual system or the periodic system.
Illustration 8-1 Comparison of Current Assets Presentation for Merchandising and Manufacturing Companies
Under a perpetual inventory system, a continuous record of changes in inventory is maintained in the Inventory account. That is, all purchases and sales (issues) of goods are recorded directly in the Inventory account as they occur. The accounting features of a perpetual inventory system are as follows. 1 Purchases of merchandise for resale or raw materials for production are debited to Inventory rather than to Purchases. 2 Freight-in, purchase returns and allowances, and purchase discounts are recorded in Inventory rather than in separate accounts. 3 Cost of goods sold is recognized for each sale by debiting the account, Cost of Goods Sold, and crediting Inventory. 4 Inventory is a control account that is supported by a subsidiary ledger of individual inventory records. The subsidiary records show the quantity and cost of each type of inventory on hand.
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Distinguish between perpetual and periodic inventory systems.
The perpetual inventory system provides a continuous record of the balances in both the Inventory account and the Cost of Goods Sold account. Under a computerized recordkeeping system, additions to and issuances from inventory can be recorded nearly instantaneously. The popularity and affordability of
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computerized accounting software have made the perpetual system cost-effective for many kinds of businesses. Recording sales with optical scanners at the cash register has been incorporated into perpetual inventory systems at many retail stores.
With the introduction and use of "just-in-time" (JIT) inventory order systems and better supplier relationships, inventory levels have become leaner for many companies. Wal-Mart provides a classic example of the use of tight inventory controls. Department managers use a scanner that when placed over the bar code corresponding to a particular item, will tell them how many items were sold yesterday, last week, and over the same period last year. It will tell them how many of those items are in stock, how many are on the way, and how many the neighboring Wal-Marts are carrying (in case one store runs out). Such practices have helped Wal-Mart become one of the top-ranked companies on the Fortune 500 in terms of sales.
What do the numbers mean?
Under a periodic inventory system, the quantity of inventory on hand is determined only periodically, as its name implies. All acquisitions of inventory during the accounting period are recorded by debits to a Purchases account. The total in the Purchases account at the end of the accounting period is added to the cost of the inventory on hand at the beginning of the period, to determine the total cost of the goods available for sale during the period. To compute the cost of goods sold, ending inventory is subtracted from the cost of goods available for sale. Note that under a periodic inventory system, the cost of goods sold is a residual amount that is dependent upon a physically counted ending inventory. No matter what type of inventory records are in use or how well organized the procedures for recording purchases and requisitions, the danger of loss and error is always present. Waste, breakage, theft, improper entry, failure to prepare or record requisitions, and any number of similar possibilities may cause the inventory records to differ from the actual inventory on hand. This requires periodic verification of the inventory records by actual count, weight, or measurement. These counts are compared with the detailed inventory records. The records are corrected to agree with the quantities actually on hand. Insofar as possible, the physical inventory should be taken near the end of a company's fiscal year so that correct inventory quantities are available in preparing annual accounting reports. Because this is not always possible, however, physical inventories taken within two or three months of the year's end are satisfactory, if the detailed inventory records are maintained with a fair degree of accuracy.4
In recent years, some companies have developed methods of determining inventories, including statistical sampling, that are sufficiently reliable to make unnecessary an annual physical count of each item of inventory. However, most companies need more current information regarding their inventory levels to protect against stockouts or overpurchasing and to aid in the preparation of monthly or quarterly financial data. As a consequence, many companies use a modified perpetual inventory system in which increases and decreases in quantities only--not dollar amounts--are kept in a detailed inventory record. It is merely a memorandum device outside the double-entry system, which helps in determining the level of inventory at any point in time.
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Inventory Classification and Systems N To illustrate the difference between a perpetual and a periodic system, assume that Fesmire Company had the following transactions during the current year.
Beginning inventory Purchases Sales Ending inventory
100 900 600 400
units units units units
at at at at
$ 6 $ 6 $12 $ 6
$ 600 $5,400 $7,200 $2,400
The entries to record these transactions during the current year are shown in Illustration 8-2.
Perpetual Inventory System
Periodic Inventory System
1. Beginning inventory, 100 units at $6: The inventory account shows the inventory The inventory account shows the inventory on hand at $600. on hand at $600. 2. Purchase 900 units at $6: Inventory 5,400 Accounts Payable 3. Sale of $600 units at $12: Accounts Receivable 7,200 Sales Cost of Goods Sold 3,600 (600 at $6) Inventory Purchases Accounts Payable Accounts Receivable Sales (No entry) 5,400 5,400 7,200 7,200
Illustration 8-2 Comparative Entries-- Perpetual vs. Periodic
4. End-of-period entries for inventory accounts, 400 units at $6: No entry necessary. Inventory (ending, by count) 2,400 The account, Inventory, shows the ending Cost of Goods Sold 3,600 balance of $2,400 Purchases ($600 $5,400 $3,600). Inventory (beginning)
When a perpetual inventory system is used and a difference exists between the perpetual inventory balance and the physical inventory count, a separate entry is needed to adjust the perpetual inventory account. To illustrate, assume that at the end of the reporting period, the perpetual inventory account reported an inventory balance of $4,000, but a physical count indicated $3,800 was actually on hand. The entry to record the necessary writedown is as follows.
Inventory Over and Short Inventory 200 200
Perpetual inventory overages and shortages generally represent a misstatement of cost of goods sold. The difference is a result of normal and expected shrinkage, breakage, shoplifting, incorrect record keeping, and the like. Inventory Over and Short would therefore be an adjustment of Cost of Goods Sold. In practice, the account Inventory Over and Short is sometimes reported in the "Other revenues and gains" or "Other expenses and losses" section of the income statement, depending on its balance. Note that in a periodic inventory system the account Inventory Over and Short does not arise; there are no accounting records available against which to compare the physical count. Thus, inventory overages and shortages are buried in cost of goods sold.
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Basic Issues in Inventory Valuation
The valuation of inventories can be a complex process that requires determining the following. 1 The physical goods to be included in inventory (who owns the goods?--goods in transit, consigned goods, special sales agreements). 2 The costs to be included in inventory (product vs. period costs). 3 The cost flow assumption to be adopted (specific identification, average cost, FIFO, LIFO, retail, etc.). We will explore these basic issues in the next three sections.
Physical Goods Included in Inventory
Technically, purchases should be recorded when legal title to the goods passes to the buyer. General practice, however, is to record acquisitions when the goods are received, because it is difficult for the buyer to determine the exact time of legal passage of title for every purchase. In addition, no material error is likely to result from such a practice if it is consistently applied. Exceptions to the general rule can arise for goods in transit and consigned goods.
Goods in Transit
Sometimes purchased merchandise is in transit--not yet received--at the end of a fiscal period. The accounting for these shipped goods depends on who owns them. That can be determined by application of the "passage of title" rule. If the goods are shipped f.o.b. shipping point, title passes to the buyer when the seller delivers the goods to the common carrier, who acts as an agent for the buyer. (The abbreviation f.o.b. stands for free on board.) If the goods are shipped f.o.b. destination, title does not pass until the buyer receives the goods from the common carrier. "Shipping point" and "destination" are often designated by a particular location, for example, f.o.b. Denver. The accounting rule is that goods to which legal title has passed should be recorded as purchases of the fiscal period. Goods shipped f.o.b. shipping point that are in transit at the end of the period belong to the buyer and should be shown in the buyer's records. Legal title to these goods passed to the buyer when the goods were shipped. To disregard such purchases would result in an understatement of inventories and accounts payable in the balance sheet and an understatement of purchases and ending inventories in the income statement.
A specialized method of marketing certain products uses a device known as a consignment shipment. Under this arrangement, one party (the consignor) ships merchandise to another (the consignee), who acts as the consignor's agent in selling the consigned goods. The consignee agrees to accept the goods without any liability, except to exercise due care and reasonable protection from loss or damage, until the goods are sold to a third party. When the consignee sells the goods, the revenue less a selling commission and expenses incurred in accomplishing the sale is remitted to the consignor. Goods out on consignment remain the property of the consignor and are included in the consignor's inventory at purchase price or production cost. Occasionally, the inventory out on consignment is shown as a separate item, but unless the amount is large there is little need for this. Sometimes the inventory on consignment is reported in the notes to the financial statements. For example, Eagle Clothes, Inc. reported the following related to consigned goods: "Inventories consist of finished goods shipped on consignment to customers of the Company's subsidiary April-Marcus, Inc."
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Basic Issues in Inventory Valuation N The consignee makes no entry to the inventory account for goods received because they are the property of the consignor. The consignee should be extremely careful not to include any of the goods consigned as a part of inventory.
Costs Included in Inventory
One of the most important problems in dealing with inventories concerns the dollar amount at which the inventory should be carried in the accounts. The acquisition of inventories, like other assets, is generally accounted for on a basis of cost.
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Product costs are those costs that "attach" to the inventory and are recorded in the inventory account. These costs are directly connected with the bringing of goods to the place of business of the buyer and converting such goods to a salable condition. Such charges would include freight charges on goods purchased, other direct costs of acquisition, and labor and other production costs incurred in processing the goods up to the time of sale. It would seem proper also to allocate to inventories a share of any buying costs or expenses of a purchasing department, storage costs, and other costs incurred in storing or handling the goods before they are sold. However, because of the practical difficulties involved in allocating such costs and expenses, these items are not ordinarily included in valuing inventories. For a manufacturing company, costs include direct materials, direct labor, and manufacturing overhead costs. Manufacturing overhead costs include indirect materials, indirect labor, and such items as depreciation, taxes, insurance, and heat and electricity incurred in the manufacturing process.
Identify the items that should be included as inventory cost.
Selling expenses and, under ordinary circumstances, general and administrative expenses are not considered to be directly related to the acquisition or production of goods and, therefore, are not considered to be a part of inventories. Such costs are period costs. Conceptually, these expenses are as much a cost of the product as the initial purchase price and related freight charges attached to the product. Why then are these costs not considered inventoriable items? Selling expenses are generally considered as more directly related to the cost of goods sold than to the unsold inventory. In most cases, though, the costs, especially administrative expenses, are so unrelated or indirectly related to the immediate production process that any allocation is purely arbitrary. Interest costs associated with getting inventories ready for sale usually are expensed as incurred. A major argument for this approach is that interest costs are really a cost of financing. Others have argued, however, that interest costs incurred to finance activities associated with making inventories ready for sale are as much a cost of the asset as materials, labor, and overhead, and therefore should be capitalized.5 The FASB has ruled that interest costs related to assets constructed for internal use or assets produced as discrete projects (such as ships or real estate projects) for sale or lease should be capitalized.6 The FASB emphasized that these discrete projects should take considerable time, entail substantial expenditures, and be likely to involve significant amounts of interest cost. Interest costs should not be capitalized for inventories that are routinely manufactured or otherwise produced
Discussion of Inventory Errors
Underlying Concepts In capitalizing interest, both constraints--materiality and cost/benefit-- are applied.
The reporting rules related to interest cost capitalization have their greatest impact in accounting for long-term assets and, therefore, are discussed in Chapter 9.
"Capitalization of Interest Cost," Statement of Financial Accounting Standards No. 34 (Stamford, Conn.: FASB, 1979).
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in large quantities on a repetitive basis, because the informational benefit does not justify the cost. Illustration 8-3 summarizes the guidelines for determining the physical goods and costs to be included in inventory.
Illustration 8-3 Goods and Costs Included in Inventory Goods Included:
Inventory is buyer's when received except: · FOB shipping point--Buyer's at time of delivery to common carrier · Consignments--Seller's, not buyer's
Whose inventory is it and what does it cost?
Period costs--Selling expenses, general and administrative expenses, and interest cost
You may need a map
Does it really matter where companies report certain costs in their income statements? As long as all the costs are included in expenses in the computation of income, why should the "geography" matter? For e-tailers, such as Amazon.com or Drugstore.com, where certain selling costs are reported does appear to be important. Contrary to well-established retailer practices, these companies insist on reporting some selling costs--fulfillment costs related to inventory shipping and warehousing--as part of administrative expenses, instead of as cost of goods sold. While the practice doesn't affect the bottom line, it does make the e-tailers' gross margins look better. For example, in a recent quarter Amazon.com reported $265 million in these costs. Some experts thought those charges should be included in costs of goods sold, which would make Amazon's gross profit substantially lower based on traditional retailer accounting practices, as shown below.
What do the numbers mean?
Sales Cost of goods sold Gross profit Gross margin% $2,795 2,132 $ 663 24%
$2,795 2,397 $ 398 14%
Similarly, if Drugstore.com and eToys.com were to make a similar adjustment, their gross margins would go from positive to negative. Thus, if you want to be able to compare the operating results of e-tailers to other traditional retailers, it might be a good idea to have a good accounting map in order to navigate their income statements and how they report certain selling costs.
Source: Adapted from P. Elstrom, "The End of Fuzzy Math?" Business Week, e.BizNet Worth (December 11, 2000).
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Basic Issues in Inventory Valuation N
What Cost Flow Assumption Should be Adopted?
During any given fiscal period it is very likely that merchandise will be purchased at several different prices. If inventories are to be priced at cost and numerous purchases have been made at different unit costs, which of the various cost prices should be used? Conceptually, a specific identification of the given items sold and unsold seems optimal, but this measure is often not only expensive but impossible to achieve. Consequently, one of several systematic inventory cost flow assumptions is used. Indeed, the actual physical flow of goods and the cost flow assumption are often quite different. There is no requirement that the cost flow assumption adopted be consistent with the physical movement of goods. The major objective in selecting a method should be to choose the one that, under the circumstances, most clearly reflects periodic income.7 To illustrate, assume that Call-Mart Inc. had the following transactions in its first month of operations.
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Describe and compare the cost flow assumptions used in accounting for inventories.
March March March March 2 15 19 30
2,000 @ $4.00 6,000 @ $4.40
Sold or Issued
2,000 8,000 4,000 6,000 units units units units
4,000 units 2,000 @ $4.75
From this information, we can compute the ending inventory of 6,000 units and the cost of goods available for sale (beginning inventory purchases) of $43,900 [(2,000 @ $4.00) (6,000 @ $4.40) (2,000 @ $4.75)]. The question is, which price or prices should be assigned to the 6,000 units of ending inventory? The answer depends on which cost flow assumption is employed.
Specific identification calls for identifying each item sold and each item in inventory. The costs of the specific items sold are included in the cost of goods sold, and the costs of the specific items on hand are included in the inventory. This method may be used only in instances where it is practical to separate physically the different purchases made. It can be successfully applied in situations where a relatively small number of costly, easily distinguishable items are handled. In the retail trade this includes some types of jewelry, fur coats, automobiles, and some furniture. In manufacturing it includes special orders and many products manufactured under a job cost system. To illustrate the specific identification method, assume that Call-Mart Inc.'s 6,000 units of inventory is composed of 1,000 units from the March 2 purchase, 3,000 from the March 15 purchase, and 2,000 from the March 30 purchase. The ending inventory and cost of goods sold would be computed as shown in Illustration 8-4 (page 354). Conceptually, this method appears ideal because actual costs are matched against actual revenue, and ending inventory is reported at actual cost. In other words, under specific identification the cost flow matches the physical flow of the goods. On closer observation, however, this method has certain deficiencies. One argument against specific identification is that it makes it possible to manipulate net income. For example, assume that a wholesaler purchases otherwise identical plywood early in the year at three different prices. When the plywood is sold, the wholesaler can select either the lowest or the highest price to charge to expense simply by selecting the plywood from a specific lot for delivery to the customer. A busi7
"Restatement and Revision of Accounting Research Bulletins," Accounting Research Bulletin No. 43 (New York: AICPA, 1953), Ch. 4, Statement 4.
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Illustration 8-4 Specific Identification Method
March 2 March 15 March 30 Ending inventory
No. of Units
1,000 3,000 2,000 6,000
$4.00 4.40 4.75
$ 4,000 13,200 9,500 $26,700
Cost of goods available for sale (computed in previous section) Deduct: Ending inventory Cost of goods sold
$43,900 26,700 $17,200
ness manager, therefore, can manipulate net income simply by delivering to the customer the higher- or lower-priced item, depending on whether higher or lower reported earnings is desired for the period. Another problem relates to the arbitrary allocation of costs that sometimes occurs with specific inventory items. In certain circumstances, it is difficult to relate adequately, for example, shipping charges, storage costs, and discounts directly to a given inventory item. The alternative, then, is to allocate these costs somewhat arbitrarily, which leads to a "breakdown" in the precision of the specific identification method.8
As the name implies, the average cost method prices items in the inventory on the basis of the average cost of all similar goods available during the period. To illustrate, assuming that Call-Mart Inc. used the periodic inventory method, the ending inventory and cost of goods sold would be computed as follows using a weighted-average method.
Illustration 8-5 Weighted-Average Method--Periodic Inventory
Date of Invoice
March 2 March 15 March 30 Total goods available
2,000 6,000 2,000 10,000
$4.00 4.40 4.75
$ 8,000 26,400 9,500 $43,900
Weighted-average cost per unit Inventory in units Ending inventory
6,000 units 6,000 $4.39 $43,900 26,340 $17,560
Cost of goods available for sale Deduct: Ending inventory Cost of goods sold
A good illustration of the cost allocation problem arises in the motion picture industry. Often actors receive a percentage of net income for a given movie or television program. Some actors who had these arrangements have alleged that their programs have been extremely profitable to the motion picture studios but they have received little in the way of profit sharing. Actors contend that the studios allocate additional costs to successful projects to ensure that there will be no profits to share.
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Basic Issues in Inventory Valuation N A beginning inventory, if any, is included both in the total units available and in the total cost of goods available in computing the average cost per unit. Another average cost method is the moving-average method, which is used with perpetual inventory records. The application of the average cost method for perpetual records is shown in Illustration 8-6.
March 2 March 15 March 19 March 30
(2,000 @ $4.00) $ 8,000 (6,000 @ 4.40) 26,400
Sold or Issued
(2,000 @ $4.00) $ 8,000 (8,000 @ 4.30) 34,400
Illustration 8-6 Moving-Average Method--Perpetual Inventory
(4,000 @ $4.30) $17,200 (2,000 @ 4.75) 9,500
(4,000 @ 4.30) (6,000 @ 4.45)
In this method, a new average unit cost is computed each time a purchase is made. On March 15, after 6,000 units are purchased for $26,400, 8,000 units costing $34,400 ($8,000 plus $26,400) are on hand. The average unit cost is $34,400 divided by 8,000, or $4.30. This unit cost is used in costing withdrawals until another purchase is made, when a new average unit cost is computed. Accordingly, the cost of the 4,000 units withdrawn on March 19 is shown at $4.30, a total cost of goods sold of $17,200. On March 30, following the purchase of 2,000 units for $9,500, a new unit cost of $4.45 is determined for an ending inventory of $26,700. The use of the average cost methods is usually justified on the basis of practical rather than conceptual reasons. These methods are simple to apply and objective. They are not as subject to income manipulation as some of the other inventory pricing methods. In addition, proponents of the average cost methods argue that it is often impossible to measure a specific physical flow of inventory and therefore it is better to cost items on an average-price basis. This argument is particularly persuasive when the inventory involved is relatively homogeneous in nature.
First-In, First-Out (FIFO)
The FIFO method assumes that goods are used in the order in which they are purchased. In other words, it assumes that the first goods purchased are the first used (in a manufacturing concern) or sold (in a merchandising concern). The inventory remaining must therefore represent the most recent purchases. To illustrate, assume that Call-Mart Inc. uses the periodic inventory system (amount of inventory computed only at the end of the month). The cost of the ending inventory is computed by taking the cost of the most recent purchase and working back until all units in the inventory are accounted for. The ending inventory and cost of goods sold are determined as shown in Illustration 8-7.
March 30 March 15 Ending inventory
2,000 4,000 6,000
$ 9,500 17,600 $27,100
Illustration 8-7 FIFO Method--Periodic Inventory
Cost of goods available for sale Deduct: Ending inventory Cost of goods sold
$43,900 27,100 $16,800
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If a perpetual inventory system in quantities and dollars is used, a cost figure is attached to each withdrawal. Then the cost of the 4,000 units removed on March 19 would be made up of the items purchased on March 2 and March 15. The inventory on a FIFO basis perpetual system for Call-Mart Inc. is shown in Illustration 8-8.
Illustration 8-8 FIFO Method--Perpetual Inventory
March 2 March 15 March 19
(2,000 @ $4.00) $ 8,000 (6,000 @ 4.40) 26,400
Sold or Issued
2,000 @ $4.00 $ 8,000 2,000 @ 4.00 34,400 6,000 @ 4.40
2,000 @ $4.00 2,000 @ 4.40 ($16,800) (2,000 @ 4.75) 9,500
4,000 @ 4.40 4,000 @ 4.40 2,000 @ 4.75
Until recently, LIFO was typically used only in the United States. However, LIFO is acceptable under the Directives of the European Union, and its use has now spread in some degree to other countries. Nonetheless, LIFO is still used primarily in the United States and is still prohibited in some countries.
The ending inventory in this situation is $27,100, and the cost of goods sold is $16,800 [(2,000 @ 4.00) (2,000 @ $4.40)]. Notice that in these two FIFO examples, the cost of goods sold ($16,800) and ending inventory ($27,100) are the same. In all cases where FIFO is used, the inventory and cost of goods sold would be the same at the end of the month whether a perpetual or periodic system is used. This is true because the same costs will always be first in and, therefore, first out. This is true whether cost of goods sold is computed as goods are sold throughout the accounting period (the perpetual system) or as a residual at the end of the accounting period (the periodic system). One objective of FIFO is to approximate the physical flow of goods. When the physical flow of goods is actually first-in, first-out, the FIFO method closely approximates specific identification. At the same time, it does not permit manipulation of income because the enterprise is not free to pick a certain cost item to be charged to expense. Another advantage of the FIFO method is that the ending inventory is close to current cost. Because the first goods in are the first goods out, the ending inventory amount will be composed of the most recent purchases. This is particularly true where the inventory turnover is rapid. This approach generally provides a reasonable approximation of replacement cost on the balance sheet when price changes have not occurred since the most recent purchases. The basic disadvantage of the FIFO method is that current costs are not matched against current revenues on the income statement. The oldest costs are charged against the more current revenue, which can lead to distortions in gross profit and net income.
Last-In, First-Out (LIFO)
The LIFO method first matches against revenue the cost of the last goods purchased. If a periodic inventory is used, then it would be assumed that the cost of the total quantity sold or issued during the month would have come from the most recent purchases. The ending inventory would be priced by using the total units as a basis of computation and disregarding the exact dates of sales or issuances. Illustration 8-9 assumes that the cost of the 4,000 units withdrawn absorbed the 2,000 units purchased on March 30 and 2,000 of the 6,000 units purchased on March 15. The inventory and related cost of goods sold would then be computed.
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Special Issues Related to LIFO N
Date of Invoice
March 2 March 15 Ending inventory
2,000 4,000 6,000
$ 8,000 17,600 $25,600
Illustration 8-9 LIFO Method--Periodic Inventory
Goods available for sale Deduct: Ending inventory Cost of goods sold
$43,900 25,600 $18,300
If a perpetual inventory record is kept in quantities and dollars, compared to the periodic record, application of the last-in, first-out method will result in different ending inventory and cost of goods sold amounts, as shown in Illustration 8-10.
March 2 March 15 March 19 March 30 (2,000 @ 4.75) 9,500
(2,000 @ $4.00) $ 8,000 (6,000 @ 4.40) 26,400
Sold or Issued
2,000 2,000 6,000 2,000 2,000 2,000 2,000 2,000 @ @ @ @ @ @ @ @
$4.00 $ 8,000 4.00 34,400 4.40 4.00 16,800 4.40 4.00 4.40 26,300 4.75
Illustration 8-10 LIFO Method--Perpetual Inventory
(4,000 @ $4.40) $17,600
The month-end periodic inventory computation presented in Illustration 8-9 (inventory $25,600 and cost of goods sold $18,300) shows a different amount from the perpetual inventory computation (inventory $26,300 and cost of goods sold $17,600). The periodic system matches the total withdrawals for the month with the total purchases for the month in applying the last-in, first-out method. In contrast, the perpetual system matches each withdrawal with the immediately preceding purchases. In effect, the periodic computation assumed that the cost of the goods that were purchased on March 30 were included in the sale or issue on March 19.
Tutorial on Inventory Methods
Special Issues Related to LIFO
Many companies use LIFO for tax and external reporting purposes, but maintain a FIFO, average cost, or standard cost system for internal reporting purposes. There are several reasons to do so: (1) Companies often base their pricing decisions on a FIFO, average, or standard cost assumption, rather than on a LIFO basis. (2) Record keeping on some other basis is easier because the LIFO assumption usually does not approximate the physical flow of the product. (3) Profit-sharing and other bonus arrangements are often not based on a LIFO inventory assumption. Finally, (4) the use of a pure LIFO system is troublesome for interim periods, for which estimates must be made of yearend quantities and prices. The difference between the inventory method used for internal reporting purposes and LIFO is referred to as the Allowance to Reduce Inventory to LIFO or the LIFO reserve. The change in the allowance balance from one period to the next is called the LIFO effect. The LIFO effect is the adjustment that must be made to the accounting records in a given year.
OB JECT IVE
Explain the significance and use of a LIFO reserve.
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To illustrate, assume that Acme Boot Company uses the FIFO method for internal reporting purposes and LIFO for external reporting purposes. At January 1, 2004, the Allowance to Reduce Inventory to LIFO balance was $20,000, and the ending balance should be $50,000. The LIFO effect is therefore $30,000, and the following entry is made at year-end.
Cost of Goods Sold Allowance to Reduce Inventory to LIFO 30,000 30,000
The Allowance to Reduce Inventory to LIFO would be deducted from inventory to ensure that the inventory is stated on a LIFO basis at year-end. The AICPA Task Force on LIFO Inventory Problems concluded that either the LIFO reserve or the replacement cost of the inventory should be disclosed.9 An example of this kind of disclosure is shown below.
Illustration 8-11 Note Disclosure of LIFO Reserve Inventories, (Note 1) BROWN SHOE, INC. (in thousands) 1999 $365,989 1998 $362,274
Additional LIFO Reserve Disclosures
Note 1 (partial): Inventories. Inventories are valued at the lower of cost or market determined principally by the last-in, first-out (LIFO) method. If the first-in, firstout (FIFO) cost method had been used, inventories would have been $11,709 higher in 1999 and $13,424 higher in 1998.
6 Explain the
OB JECT IVE
Up to this point, we have emphasized a specific goods approach to costing LIFO inventories (also called traditional LIFO or unit LIFO). This approach is often unrealistic for two reasons: 1 When a company has many different inventory items, the accounting cost of keeping track of each inventory item is expensive. 2 Erosion of the LIFO inventory can easily occur. Referred to as LIFO liquidation, this often leads to distortions of net income and substantial tax payments.
effect of LIFO liquidations.
To understand the LIFO liquidation problem, assume that Basler Co. has 30,000 pounds of steel in its inventory on December 31, 2004, costed on a specific goods LIFO approach.
Ending Inventory (2004)
2001 2002 2003 2004 8,000 10,000 7,000 5,000 30,000
$4 6 9 10
$ 32,000 60,000 63,000 50,000 $205,000
The AICPA Task Force on LIFO Inventory Problems, Issues Paper (New York: AICPA, November 30, 1984), par. 224. The SEC has endorsed this issues paper, and therefore it has authoritative status for GAAP purposes.
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Special Issues Related to LIFO N As indicated, the ending 2004 inventory for Basler Co. comprises costs from past periods. These costs are called layers (increases from period to period). The first layer is identified as the base layer. The layers for Basler are shown in Illustration 8-12.
2004 Layer 2003 Layer 2002 Layer 2001 Base layer
$50,000 (5,000 × $10) $63,000 (7,000 × $9) $60,000 (10,000 × $6) $32,000 (8,000 × $4)
Illustration 8-12 Layers of LIFO Inventory
The price of steel has increased over the 4-year period. In 2005, Basler Co. experienced metal shortages and had to liquidate much of its inventory (a LIFO liquidation). At the end of 2005, only 6,000 pounds of steel remained in inventory. Because the company is using LIFO, the most recent layer, 2004, is liquidated first, followed by the 2003 layer, and so on. The result: Costs from preceding periods are matched against sales revenues reported in current dollars. This leads to a distortion in net income and a substantial tax bill in the current period. These effects are shown in Illustration 8-13. Unfortunately LIFO liquidations can occur frequently when a specific goods LIFO approach is employed.
Illustration 8-13 LIFO Liquidation
Result Sales Revenue (All Current Prices)
$50,000 (5,000 × $10)
Sold 5,000 lbs.
$63,000 (7,000 × $9)
Sold 7,000 lbs.
$60,000 (10,000 × $6)
Sold 10,000 lbs. Sold 2,000 lbs.
Cost of Goods Sold (Some Current, Some Old Prices)
Higher income = and probably higher tax bill
$32,000 (8,000 × $4) (6,000 lbs. remaining)
To alleviate the LIFO liquidation problems and to simplify the accounting, goods can be combined into pools. A pool is defined as a group of items of a similar nature. Thus, instead of only identical units, a number of similar units or products are combined and accounted for together. This method is referred to as the specific goods pooled LIFO approach. With the specific goods pooled LIFO approach, LIFO liquidations are less likely to happen because the reduction of one quantity in the pool may be offset by an increase in another.
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The specific goods pooled LIFO approach eliminates some of the disadvantages of the specific goods (traditional) accounting for LIFO inventories. This pooled approach, using quantities as its measurement basis, however, creates other problems. First, most companies are continually changing the mix of their products, materials, and production methods. If a pooled approach using quantities is employed, such changes mean that the pools must be continually redefined; this can be time consuming and costly. Second, even when such an approach is practical, an erosion ("LIFO liquidation") of the layers often results, and much of the LIFO costing benefit is lost. An erosion of the layers results because a specific good or material in the pool may be replaced by another good or material either temporarily or permanently. The new item may not be similar enough to be treated as part of the old pool. Therefore any inflationary profit deferred on the old goods may have to be recognized as the old goods are replaced.
OB JECT IVE
Explain the dollarvalue LIFO method.
To overcome the problems of redefining pools and eroding layers, the dollar-value LIFO method was developed. An important feature of the dollar-value LIFO method is that increases and decreases in a pool are determined and measured in terms of total dollar value, not the physical quantity of the goods in the inventory pool. Such an approach has two important advantages over the specific goods pooled approach. First, a broader range of goods may be included in a dollar-value LIFO pool. Second, in a dollar-value LIFO pool, replacement is permitted if it is a similar material, or similar in use, or interchangeable. (In contrast, in a specific goods LIFO pool, an item may be replaced only with an item that is substantially identical.) Thus, dollar-value LIFO techniques help protect LIFO layers from erosion. Because of this advantage, the dollar-value LIFO method is frequently used in practice.10 The more traditional LIFO approaches would be used only in situations where few goods are employed and little change in product mix is predicted. Under the dollar-value LIFO method, it is possible to have the entire inventory in only one pool, although several pools are commonly employed.11 In general, the more goods included in a pool, the more likely that decreases in the quantities of some goods will be offset by increases in the quantities of other goods in the same pool. Thus liquidation of the LIFO layers is avoided. It follows that having fewer pools means less cost and less chance of a reduction of a LIFO layer.
Dollar-Value LIFO Illustration
To illustrate how the dollar-value LIFO method works, assume that dollar-value LIFO was first adopted (base period) on December 31, 2003. The inventory at current prices on that date was $20,000, and the inventory on December 31, 2004, at current prices is $26,400. We should not conclude that the quantity has increased 32 percent during the year ($26,400 $20,000 132%). First, we need to ask: What is the value of the ending inventory in terms of beginning-of-the-year prices? Assuming that prices have increased 20 percent during the year, the ending inventory at beginning-of-the-year prices
10 A study by James M. Reeve and Keith G. Stanga disclosed that the vast majority of respondent companies applying LIFO use the dollar-value method or the dollar-value retail method to apply LIFO. Only a small minority of companies use the specific goods (unit LIFO) approach or the specific goods pooling approach. See J.M. Reeve and K.G. Stanga, "The LIFO Pooling Decision," Accounting Horizons (June 1987), p. 27. 11
The Reeve and Stanga study (ibid.) reports that most companies have only a few pools-- the median is six for retailers and three for nonretailers. But the distributions are highly skewed; some companies have 100 or more pools. Retailers that use LIFO have significantly more pools than nonretailers. About a third of the nonretailers (mostly manufacturers) use a single pool for their entire LIFO inventory.
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Special Issues Related to LIFO N amounts to $22,000 ($26,400 120%). Therefore, the inventory quantity has increased 10 percent, or from $20,000 to $22,000 in terms of beginning-of-the-year prices. The next step is to price this real-dollar quantity increase. This real-dollar quantity increase of $2,000 valued at year-end prices is $2,400 (120% $2,000). This increment (layer) of $2,400, when added to the beginning inventory of $20,000, gives a total of $22,400 for the December 31, 2004, inventory, as shown below.
First layer--(beginning inventory) in terms of 100 Second layer--(2004 increase) in terms of 120 Dollar-value LIFO inventory, December 31, 2004
$20,000 2,400 $22,400
It should be emphasized that a layer is formed only when the ending inventory at base-year prices exceeds the beginning inventory at base-year prices. And only when a new layer is formed must a new index be computed.
Comprehensive Dollar-Value LIFO Illustration
To illustrate the use of the dollar-value LIFO method in a more complex situation, assume that Bismark Company develops the following information.
(Base year) 2001 2002 2003 2004
Inventory at End-of-Year Prices
$200,000 299,000 300,000 351,000
Price Index (percentage)
100 115 120 130
End-of-Year Inventory at Base-Year Prices
$200,000 260,000 250,000 270,000
At December 31, 2001, the ending inventory under dollar-value LIFO is simply the $200,000 computed as shown in Illustration 8-14.
Illustration 8-14 Computation of 2001 Inventory at LIFO Cost
Ending Inventory at Base-Year Prices
Layer at Base-Year Prices
Price Index (percentage)
Ending Inventory at LIFO Cost
At December 31, 2002, a comparison of the ending inventory at base-year prices ($260,000) with the beginning inventory at base-year prices ($200,000), indicates that the quantity of goods has increased $60,000 ($260,000 $200,000). This increment (layer) is then priced at the 2002 index of 115 percent to arrive at a new layer of $69,000. Ending inventory for 2002 is $269,000, composed of the beginning inventory of $200,000 and the new layer of $69,000. The computations are in Illustration 8-15 (page 362). At December 31, 2003, a comparison of the ending inventory at base-year prices ($250,000) with the beginning inventory at base-year prices ($260,000) indicates that the quantity of goods has decreased $10,000 ($250,000 $260,000). If the ending inventory at base-year prices is less than the beginning inventory at base-year prices, the decrease must be subtracted from the most recently added layer. When a decrease occurs, previous layers must be "peeled off" at the prices in existence when the layers were added. In Bismark Company's situation, this means that $10,000 in base-year prices
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Illustration 8-15 Computation of 2002 Inventory at LIFO Cost
Ending Inventory at Base-Year Prices
Layers at Base-Year Prices
2001 $200,000 2002 60,000 $260,000
Price Index (percentage)
Ending Inventory at LIFO Cost
$200,000 69,000 $269,000
must be removed from the 2002 layer of $60,000 at base-year prices. The balance of $50,000 ($60,000 $10,000) at base-year prices must be valued at the 2002 price index of 115 percent, so this 2002 layer now is valued at $57,500 ($50,000 115%). The ending inventory is therefore computed at $257,500, consisting of the beginning inventory of $200,000 and the second layer, $57,500. The computations for 2003 are shown in Illustration 8-16.
Illustration 8-16 Computation of 2003 Inventory at LIFO Cost
Ending Inventory at Base-Year Prices
Layers at Base-Year Prices
2001 $200,000 2002 50,000 $250,000
Price Index (percentage)
Ending Inventory at LIFO Cost
$200,000 57,500 $257,500
Note that if a layer or base (or portion thereof) has been eliminated, it cannot be rebuilt in future periods. That is, it is gone forever. At December 31, 2004, a comparison of the ending inventory at base-year prices ($270,000) with the beginning inventory at base-year prices ($250,000) indicates that the dollar quantity of goods has increased $20,000 ($270,000 $250,000) in terms of baseyear prices. After converting the $20,000 increase to the 2004 price index, the ending inventory is $283,500, composed of the beginning layer of $200,000, a 2002 layer of $57,500, and a 2004 layer of $26,000 ($20,000 130%). This computation is shown in Illustration 8-17.
Illustration 8-17 Computation of 2004 Inventory at LIFO Cost
Ending Inventory at Base-Year Prices $270,000
Layers at Base-Year Prices 2001 $200,000 2002 50,000 2003 20,000 $270,000
Price Index (percentage) 100 115 130
Ending Inventory at LIFO Cost $200,000 57,500 26,000 $283,500
The ending inventory at base-year prices must always equal the total of the layers at base-year prices. Checking that this situation exists will help to ensure that the dollar-value computation is made correctly.
Comparison of LIFO Approaches
Three different approaches to computing LIFO inventories are presented in this chapter--specific goods LIFO, specific goods pooled LIFO, and dollar-value LIFO. As in-
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Special Issues Related to LIFO N dicated earlier, the use of the specific goods LIFO is unrealistic because most enterprises have numerous goods in inventory at the end of a period, and costing (pricing) them on a unit basis is extremely expensive and time consuming. The specific goods pooled LIFO approach is better in that it reduces record keeping and clerical costs. In addition, it is more difficult to erode the layers because the reduction of one quantity in the pool may be offset by an increase in another. Nonetheless, the pooled approach using quantities as its measurement basis can lead to untimely LIFO liquidations. As a result, dollar-value LIFO is the method employed by most companies that currently use a LIFO system. Although the approach appears complex, the logic and the computations are actually quite simple, once an appropriate index is determined. This is not to suggest that problems do not exist with the dollar-value LIFO method. The selection of the items to be put in a pool can be subjective.12 Such a determination, however, is extremely important because manipulation of the items in a pool without conceptual justification can affect reported net income. For example, the SEC noted that some companies have set up pools that are easy to liquidate. As a result, when the company wants to increase its income, it decreases inventory, thereby matching low-cost inventory items to current revenues. To curb this practice, the SEC has taken a much harder line on the number of pools that companies may establish. In the well-publicized Stauffer Chemical Company case, Stauffer had increased the number of LIFO pools from 8 to 280, boosting its net income by $16,515,000 or approximately 13 percent.13 Stauffer justified the change in its Annual Report on the basis of "achieving a better matching of cost and revenue." The SEC required Stauffer to reduce the number of its inventory pools, contending that some pools were inappropriate and alleging income manipulation.
Tutorial on LIFO Inventory Issues
Basis for Selection of Inventory Method
How does one choose among the various inventory methods? Although no absolute rules can be stated, preferability for LIFO can ordinarily be established in either of the following circumstances: (1) if selling prices and revenues have been increasing faster than costs, thereby distorting income, and (2) in situations where LIFO has been traditional, such as department stores and industries where a fairly constant "base stock" is present (such as refining, chemicals, and glass).14 Conversely, LIFO would probably not be appropriate: (1) where prices tend to lag behind costs; (2) in situations where specific identification is traditional, such as in the sale of automobiles, farm equipment, art, and antique jewelry; or (3) where unit costs tend to decrease as production increases, thereby nullifying the tax benefit that LIFO might provide.15
Major Advantages of LIFO
One obvious advantage of LIFO approaches is that in certain situations the LIFO cost flow actually approximates the physical flow of the goods in and out of inventory. For instance, in the case of a coal pile, the last coal in is the first coal out because it is on the top of the pile. The coal remover is not going to take the coal from the botOB JECT IVE
Identify the major advantages and disadvantages of LIFO.
It is suggested that companies analyze how inventory purchases are affected by price changes, how goods are stocked, how goods are used, and if future liquidations are likely. See William R. Cron and Randall Hayes, "The Dollar Value LIFO Pooling Decision: The Conventional Wisdom Is Too General," Accounting Horizons (December 1989), p. 57.
Commerce Clearing House, SEC Accounting Rules (Chicago: CCH, 1983), par. 4035.
Accounting Trends and Techniques--2001 reports that of 887 inventory method disclosures, 283 used LIFO, 386 used FIFO, 180 used average cost, and 38 used other methods.
See Barry E. Cushing and Marc J. LeClere, "Evidence on the Determinants of Inventory Accounting Policy Choice," The Accounting Review (April 1992), pp. 355366, Table 4, p. 363, for a list of factors hypothesized to affect FIFOLIFO choices.
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tom of the pile! The coal that is going to be taken first is the coal that was placed on the pile last. However, the coal pile situation is one of only a few situations where the actual physical flow corresponds to LIFO. Therefore most adherents of LIFO use other arguments for its widespread employment, as follows. Matching In LIFO, the more recent costs are matched against current revenues to provide a better measure of current earnings. During periods of inflation, many challenge the quality of non-LIFO earnings, noting that by failing to match current costs against current revenues, transitory or "paper" profits ("inventory profits") are created. Inventory profits occur when the inventory costs matched against sales are less than the inventory replacement cost. The cost of goods sold therefore is understated and profit is overstated. Using LIFO (rather than a method such as FIFO), current costs are matched against revenues and inventory profits are thereby reduced. Tax Benefits/Improved Cash Flow Tax benefits are the major reason why LIFO has become popular. As long as the price level increases and inventory quantities do not decrease, a deferral of income tax occurs, because the items most recently purchased at the higher price level are matched against revenues. For example, when Fuqua Industries decided to switch to LIFO, it had a resultant tax savings of about $4 million. Even if the price level decreases later, the company has been given a temporary deferral of its income taxes. Thus, use of LIFO in such situations improves a company's cash flow.16 The tax law requires that if a company uses LIFO for tax purposes, it must also use LIFO for financial accounting purposes17 (although neither tax law nor GAAP requires a company to pool its inventories in the same manner for book and tax purposes). This requirement is often referred to as the LIFO conformity rule. Other inventory valuation methods do not have this requirement.
Major Disadvantages of LIFO Approaches
Despite its advantages, LIFO has the following drawbacks. Reduced Earnings Many corporate managers view the lower profits reported under the LIFO method in inflationary times as a distinct disadvantage. They would rather have higher reported profits than lower taxes. Some fear that an accounting change to LIFO may be misunderstood by investors and that, as a result of the lower profits, the price of the company's stock will fall. In fact, though, there is some evidence to refute this contention. It is questionable whether companies should switch from LIFO to FIFO for the sole purpose of increasing reported earnings.18 Intuitively one would assume that
16 In periods of rising prices, the use of fewer pools will translate into greater income tax benefits through the use of LIFO. The use of fewer pools allows inventory reductions of some items to be offset by inventory increases in others. In contrast, the use of more pools increases the likelihood that old, low-cost inventory layers will be liquidated and tax consequences will be negative. See Reeve and Stanga, ibid., pp. 2829. 17 Management often selects an accounting procedure because a lower tax results from its use, instead of an accounting method that is conceptually more appealing. Throughout this textbook, an effort has been made to identify accounting procedures that provide income tax benefits to the user.
Because of steady or falling raw materials costs and costs savings from electronic data interchange and just-in-time technologies in recent years, many businesses using LIFO are no longer experiencing substantial tax benefits from LIFO. Even some companies for which LIFO is creating a benefit are finding that the administrative costs associated with LIFO are higher than the LIFO benefit obtained. As a result, some companies are deciding to move to FIFO or average cost.
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Special Issues Related to LIFO N companies with higher reported earnings would have a higher share (common stock price) valuation. Some studies have indicated, however, that the users of financial data exhibit a much higher sophistication than might be expected. Share prices are the same and, in some cases, even higher under LIFO in spite of lower reported earnings.19 The concern about reduced income resulting from adoption of LIFO has even less substance now because the IRS has relaxed the LIFO conformity rule which required a company that employed LIFO for tax purposes to use it for book purposes as well. The IRS has relaxed restrictions against providing non-LIFO income numbers as supplementary information. As a result, the profession now permits supplemental nonLIFO disclosures. The supplemental disclosure, while not intended to override the basic LIFO method adopted for financial reporting, may be useful in comparing operating income and working capital with companies not on LIFO. Inventory Understated LIFO may have a distorting effect on a company's balance sheet. The inventory valuation is normally outdated because the oldest costs remain in inventory. This understatement makes the working capital position of the company appear worse than it really is. The magnitude and direction of this variation between the carrying amount of inventory and its current price depend on the degree and direction of the price changes and the amount of inventory turnover. The combined effect of rising product prices and avoidance of inventory liquidations increases the difference between the inventory carrying value at LIFO and current prices of that inventory, thereby magnifying the balance sheet distortion attributed to the use of LIFO.
Comparing apples to apples
A common ratio used by investors to evaluate a company's liquidity is the current ratio, which is computed as current assets divided by current liabilities. A higher current ratio indicates that a company is better able to meet its current obligations when they come due. However, it is not meaningful to compare the current ratio for a company using LIFO to one for a company using FIFO. It would be like comparing apples to oranges, since inventory (and cost of goods sold) would be measured differently for the two companies. The LIFO reserve can be used to make the current ratio comparable on an apples to apples basis. To make the LIFO company comparable to the FIFO company, the following adjustments should do the trick: Inventory Adjustment: LIFO inventory LIFO reserve FIFO inventory
What do the numbers mean?
(For cost of goods sold, the change in the LIFO reserve is added to LIFO cost of goods sold to yield the comparable FIFO amount.) For Brown Shoe, Inc. (see Illustration 8-11), with current assets of $487.8 million and current liabilities of $217.8 million, the current ratio using LIFO is: $487.8 $217.8 2.2. After adjusting for the LIFO effect, Brown's current ratio under FIFO would be: ($487.8 $11.7) $217.8 2.3. Thus, without the LIFO adjustment, the Brown Shoe current ratio is understated.
See, for example, Shyam Sunder, "Relationship Between Accounting Changes and Stock Prices: Problems of Measurement and Some Empirical Evidence," Empirical Research in Accounting: Selected Studies, 1973 (Chicago: University of Chicago), pp. 140. But see Robert Moren Brown, "Short-Range Market Reaction to Changes to LIFO Accounting Using Preliminary Earnings Announcement Dates," The Journal of Accounting Research (Spring 1980), which found that companies that do change to LIFO suffer a short-run decline in the price of their stock.
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Physical Flow LIFO does not approximate the physical flow of the items except in peculiar situations (such as the coal pile). Originally LIFO could be used only in certain circumstances. This situation has changed over the years to the point where physical flow characteristics no longer play an important role in determining whether LIFO may be employed. Involuntary Liquidation/Poor Buying Habits If the base or layers of old costs are eliminated, strange results can occur because old, irrelevant costs can be matched against current revenues. A distortion in reported income for a given period may result, as well as consequences that are detrimental from an income tax point of view.20 Because of the liquidation problem, LIFO may cause poor buying habits. A company may simply purchase more goods and match these goods against revenue to ensure that the old costs are not charged to expense. Furthermore, the possibility always exists with LIFO that a company will attempt to manipulate its net income at the end of the year simply by altering its pattern of purchases.21 One survey uncovered the following reasons why companies reject LIFO.22
Illustration 8-18 Why Do Companies Reject LIFO? Summary of Responses
Reasons to Reject LIFO
No expected tax benefits No required tax payment Declining prices Rapid inventory turnover Immaterial inventory Miscellaneous tax related Regulatory or other restrictions Excessive cost High administrative costs LIFO liquidationrelated costs Other adverse consequences Lower reported earnings Bad accounting
34 31 30 26 38 159 26 29 12 41 18 7 25
% of Total*
16% 15 14 12 17 74% 12% 14% 6 20% 8% 3 11%
Despite an effort to eliminate it, LIFO remains acceptable under international accounting standards.
*Percentage totals more than 100% as some companies offered more than one explanation.
Often the inventory methods are used in combination with other methods. For example, most companies never use LIFO totally, but rather use it in combination with other valuation approaches. One reason is that certain product lines can be highly susceptible to deflation instead of inflation. In addition, if the level of inventory is unstable, unwanted involuntary liquidations may result in certain product lines if LIFO is used. Finally, where inventory turnover in certain product lines is high, the additional
The AICPA Task Force on LIFO Inventory Problems recommends that the effects on income of LIFO inventory liquidations be disclosed in the notes to the financial statements, but that the effects not receive special treatment in the income statement. Issues Paper (New York: AICPA, 1984), pp. 3637. For example, one reason why General Tire and Rubber at one time accelerated raw material purchases at the end of the year was to minimize the book profit from a liquidation of LIFO inventories and to minimize income taxes for the year.
22 21 20
Michael H. Granof and Daniel Short, "Why Do Companies Reject LIFO?" Journal of Accounting, Auditing, and Finance (Summer 1984), pp. 323333, Table 1, p. 327.
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Lower of Cost or Market N recordkeeping and expense are not justified by LIFO. Average cost is often used in such cases because it is easy to compute.23 This variety of inventory methods has been devised to assist in accurate computation of net income rather than to permit manipulation of reported income. Hence, it is recommended that the pricing method most suitable to a company be selected and, once selected, be applied consistently thereafter. If conditions indicate that the inventory pricing method in use is unsuitable, serious consideration should be given to all other possibilities before selecting another method. Any change should be clearly explained and its effect disclosed in the financial statements. To improve comparability of its LIFO inventory amounts, JC Penney, Inc. presented the following information in its Annual Report.
JC PENNEY, INC. Some companies in the retail industry use the FIFO method in valuing part or all of their inventories. Had JC Penney used the FIFO method and made no other assumptions with respect to changes in income resulting therefrom, income and income per share from continuing operations would have been: Income from continuing operations (in millions) Income from continuing operations per share $325 $4.63
Illustration 8-19 Supplemental Non-LIFO Disclosure
Lower of Cost or Market
Inventories are recorded at their cost. However, a major departure from the historical cost principle is made in the area of inventory valuation if inventory declines in value below its original cost. Whatever the reason for a decline--obsolescence, price-level changes, damaged goods, and so forth--the inventory should be written down to reflect this loss. The general rule is that the historical cost principle is abandoned when the future utility (revenue-producing ability) of the asset is no longer as great as its original cost. Inventories that experience a decline in utility are valued therefore on the basis of the lower of cost or market, instead of on an original cost basis. Cost is the acquisition price of inventory computed using one of the historical cost-based methods--specific identification, average cost, FIFO, or LIFO. The term market in the phrase "the lower of cost or market" (LCM) generally means the cost to replace the item by purchase or reproduction. In a retailing business the term "market" refers to the market in which goods were purchased, not the market in which they are sold. In manufacturing, the term "market" refers to the cost to reproduce. Thus the rule really means that goods are to be valued at cost or cost to replace, whichever is lower. For example, a Casio calculator wristwatch that costs a retailer $30.00 when purchased, that can be sold for $48.95, and that can be replaced for $25.00 should be valued at $25.00 for inventory purposes under the lower of cost or market rule. The lower of cost or market rule of valuation can be used after any of the cost flow methods discussed above have been applied to determine the inventory cost. A departure from cost is justified because a loss of utility should be charged against revenues in the period in which the loss occurs, not in the period in which it is sold.
For an interesting discussion of the reasons for and against the use of FIFO and average cost, see Michael H. Granof and Daniel G. Short "For Some Companies, FIFO Accounting Makes Sense," Wall Street Journal (August 30, 1982), and the subsequent rebuttal by Gary C. Biddle "Taking Stock of Inventory Accounting Choices," Wall Street Journal (September 15, 1982).
OB JECT IVE
Explain and apply the lower of cost or market rule.
Underlying Concepts The use of the lower of cost or market rule is an excellent example of the conservatism constraint.
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In addition, the lower of cost or market method is a conservative approach to inventory valuation. That is, when doubt exists about the value of an asset, it is preferable to undervalue rather than to overvalue it.
Lower of Cost or Market--Ceiling and Floor
Why use replacement cost to represent market value? The reason is that a decline in the replacement cost of an item usually reflects or predicts a decline in selling price. Using replacement cost allows a company to maintain a consistent rate of gross profit on sales (normal profit margin). Sometimes, however, a reduction in the replacement cost of an item does not indicate a corresponding reduction in its utility. Then, two additional valuation limitations are used to value ending inventory--net realizable value and net realizable value less a normal profit margin. Net realizable value (NRV) is defined as the estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal. A normal profit margin is subtracted from that amount to arrive at net realizable value less a normal profit margin. To illustrate, assume that Jerry Mander Corp. has unfinished inventory with a sales value of $1,000, estimated cost of completion of $300, and a normal profit margin of 10 percent of sales. The following net realizable value can be determined.
Illustration 8-20 Computation of Net Realizable Value
Inventory--sales value Less: Estimated cost of completion and disposal Net realizable value Less: Allowance for normal profit margin (10% of sales) Net realizable value less a normal profit margin
$1,000 300 700 100 $ 600
Underlying Concepts Setting a floor and a ceiling increases the relevancy of the inventory presentation. The inventory figure provides a better understanding of how much revenue the inventory will generate.
The general rule of lower of cost or market is: Inventory is valued at the lower of cost or market, with market limited to an amount that is not more than net realizable value or less than net realizable value less a normal profit margin.24 What is the rationale for these two limitations? The upper (ceiling) and lower (floor) limits for the value of the inventory are intended to prevent the inventory from being reported at an amount in excess of the net selling price or at an amount less than the net selling price less a normal profit margin. The maximum limitation, not to exceed the net realizable value (ceiling), covers obsolete, damaged, or shopworn material and prevents overstatement of inventories and understatement of the loss in the current period. That is, if the replacement cost of an item is greater than its net realizable value, inventory should not be reported at replacement cost because the company can receive only the selling price less cost of disposal. To report the inventory at replacement cost would result in an overstatement of inventory and an understated loss in the current period. To illustrate, assume that Staples paid $1,000 for a laser printer that can now be replaced for $900 and whose net realizable value is $700. At what amount should the laser printer be reported in the financial statements? To report the replacement cost of $900 overstates the ending inventory and understates the loss for the period. The printer should, therefore, be reported at $700. The minimum limitation is not to be less than net realizable value reduced by an allowance for an approximately normal profit margin (floor). This deters understatement of inventory and overstatement of the loss in the current period. It establishes a floor below which the inventory should not be priced regardless of replace24
"Restatement and Revision of Accounting Research Bulletins," Accounting Research Bulletin No. 43 (New York: AICPA, 1953), Ch. 4, par. 8.
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Lower of Cost or Market N ment cost. It makes no sense to price inventory below net realizable value less a normal margin because this minimum amount (floor) measures what the company can receive for the inventory and still earn a normal profit. These guidelines are illustrated graphically in Illustration 8-21.
Illustration 8-21 Inventory Valuation-- Lower of Cost or Market
Not More Than Cost Market Replacement Cost Not Less Than GAAP Lower of Cost or Market NRV less Normal Profit Margin Floor
How Lower of Cost or Market Works
The amount that is compared to cost, often referred to as designated market value, is always the middle value of three amounts: replacement cost, net realizable value, and net realizable value less a normal profit margin. To illustrate how designated market value is computed, assume the following information relative to the inventory of Regner Foods, Inc.
Spinach Carrots Cut beans Peas Mixed vegetables
$ 88,000 90,000 45,000 36,000 105,000
Net Realizable Value (Ceiling)
$120,000 100,000 40,000 72,000 92,000
Net Realizable Value Less a Normal Profit Margin (Floor)
$104,000 70,000 27,500 48,000 80,000
Designated Market Value
$104,000 90,000 40,000 48,000 92,000
Illustration 8-22 Computation of Designated Market Value
Designated Market Value Decision:
Spinach Net realizable value less a normal profit margin is selected because it is the middle value. Carrots Replacement cost is selected because it is the middle value. Cut beans Net realizable value is selected because it is the middle value. Peas Net realizable value less a normal profit margin is selected because it is the middle value. Mixed vegetables Net realizable value is selected because it is the middle value.
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Designated market value is then compared to cost to determine the lower of cost or market. To illustrate, the final inventory value for Regner Foods is determined as follows.
Illustration 8-23 Determining Final Inventory Value Food Spinach Carrots Cut beans Peas Mixed vegetables Cost $ 80,000 100,000 50,000 90,000 95,000
Replacement Cost $ 88,000 90,000 45,000 36,000 105,000
Net Realizable Value (Ceiling) $120,000 100,000 40,000 72,000 92,000
Net Realizable Value Less a Normal Profit Margin (Floor) $104,000 70,000 27,500 48,000 80,000
Designated Market Value $104,000 90,000 40,000 48,000 92,000
Final Inventory Value $ 80,000 90,000 40,000 48,000 92,000 $350,000
Final Inventory Value:
Spinach Carrots Cut beans Peas Mixed vegetables Cost ($80,000) is selected because it is lower than designated market value (net realizable value less a normal profit margin). Designated market value (replacement cost, $90,000) is selected because it is lower than cost. Designated market value (net realizable value, $40,000) is selected because it is lower than cost. Designated market value (net realizable value less a normal profit margin, $48,000) is selected because it is lower than cost. Designated market value (net realizable value, $92,000) is selected because it is lower than cost.
The application of the lower of cost or market rule incorporates only losses in value that occur in the normal course of business from such causes as style changes, shift in demand, or regular shop wear. Damaged or deteriorated goods are reduced to net realizable value. When material, such goods may be carried in separate inventory accounts.
Methods of Applying Lower of Cost or Market
In the Regner Foods illustration, we assumed that the lower of cost or market rule was applied to each individual type of food. However, the lower of cost or market rule may be applied either directly to each item, to each category, or to the total of the inventory. Increases in market prices tend to offset decreases in market prices, if a major category or total inventory approach is followed in applying the lower of cost or market rule. To illustrate, assume that Regner Foods separates its food products into two major categories, frozen and canned, as shown in Illustration 8-24 (next page). If the lower of cost or market rule is applied to individual items, the amount of inventory is $350,000. If the rule is applied to major categories, it is $370,000. If LCM is applied to the total inventory, it is $374,000. The reason for the difference is that market values higher than cost are offset against market values lower than cost when the major categories or total inventory approach is adopted. For Regner Foods, the high market value for spinach is partially offset when the major categories approach is adopted, and it is totally offset when the total inventory approach is used. The most common practice is to price the inventory on an item-by-item basis. For one thing, tax rules require that an individual-item basis be used unless doing so in-
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Lower of Cost or Market N
Lower of Cost or Market By: Cost
Frozen Spinach Carrots Cut beans Total frozen Canned Peas Mixed vegetables Total canned Total $ 80,000 100,000 50,000 230,000 90,000 95,000 185,000 $415,000
$104,000 90,000 40,000 234,000 48,000 92,000 140,000 $374,000
$ 80,000 90,000 40,000
Illustration 8-24 Alternative Applications of Lower of Cost or Market
$230,000 48,000 92,000 140,000 $350,000 $370,000 $374,000
volves practical difficulties. In addition, the individual-item approach gives the most conservative valuation for balance sheet purposes.25 Inventory is often priced on a totalinventory basis when there is only one end product (comprised of many different raw materials), because the main concern is the pricing of the final inventory. If several end products are produced, a category approach might be used. The method selected should be the one that most clearly reflects income. Whichever method is selected, it should be applied consistently from one period to another.26
Evaluation of the Lower of Cost or Market Rule
The lower of cost or market rule suffers some conceptual deficiencies: 1 Decreases in the value of the asset and the charge to expense are recognized in the period in which the loss in utility occurs--not in the period of sale. On the other hand, increases in the value of the asset are recognized only at the point of sale. This treatment is inconsistent and can lead to distortions in income data. 2 Application of the rule results in inconsistency because the inventory of a company may be valued at cost in one year and at market in the next year. 3 Lower of cost or market values the inventory in the balance sheet conservatively, but its effect on the income statement may or may not be conservative. Net income for the year in which the loss is taken is definitely lower. Net income of the subsequent period may be higher than normal if the expected reductions in sales price do not materialize. 4 Application of the lower of cost or market rule uses a "normal profit" in determining inventory values. Since "normal profit" is an estimated figure based
25 If a company uses dollar-value LIFO, determining the LIFO cost of an individual item may be more difficult. The company might decide that it is more appropriate to apply the lower of cost or market rule to the total amount of each pool. The AICPA Task Force on LIFO Inventory Problems concluded that the most reasonable approach to applying the lower of cost or market provisions to LIFO inventories is to base the determination on reasonable groupings of items and that a pool constitutes a reasonable grouping. 26
Underlying Concepts The inconsistency in the presentation of inventory is an example of the trade-off between relevancy and reliability. Market is more relevant than cost, and cost is more reliable than market. Apparently, relevance takes precedence in a down market, and reliability is more important than relevancy in an up market.
Inventory accounting for financial statement purposes can be different from income tax purposes. For example, the lower of cost or market rule cannot be used with LIFO for tax purposes. There is nothing, however, to prevent the use of the lower of cost or market and LIFO for financial accounting purposes.
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upon past experience (and might not be attained in the future), it is not objective in nature and presents an opportunity for income manipulation.
Many financial statement users appreciate the lower of cost or market rule because they at least know that the inventory is not overstated. In addition, recognizing all losses but anticipating no gains generally results in lower income.
All its berries in one basket
The latest quarter has not been very good for Northland Cranberries. The Wisconsin cranberry producer reported lower sales compared to the same quarter in the prior year and an operating loss:
What do the numbers mean?
Revenues Net income
Same Quarter, Prior Year
Things are so bad that Northland is in violation of several debt covenants and looking to sell assets in order to generate cash for paying it debts. What is behind these dismal numbers? Northland cites declining market prices for cranberries which have led the company to take an inventory write-down of $30.4 million in the current quarter. All companies in this industry are affected by declining market prices for cranberries, but Northland is particularly vulnerable because so much of its business is concentrated in the cranberry market. What's more, Northland is a small competitor in a cranberry and juice market dominated by major producers, such as Ocean Spray, Tropicana (owned by PepsiCo), and Minute-Maid (owned by Coca-Cola). These large producers are able to withstand market pressures in the cranberry market with sales in other juices and beverages. Northland must take its lumps in the cranberry market with inventory write-downs and operating losses.
Presentation and Analysis
Presentation of Inventories
OB JECT IVE
Explain how inventory is reported and analyzed.
Additional Inventory Disclosures
Accounting standards require financial statement disclosure of the composition of the inventory, inventory financing arrangements, and the inventory costing methods employed. The standards also require the consistent application of costing methods from one period to another. Manufacturers should report the inventory composition either in the balance sheet or in a separate schedule in the notes. The relative mix of raw materials, work in process, and finished goods is important in assessing liquidity and in computing the stage of inventory completion. Significant or unusual financing arrangements relating to inventories may require note disclosure. Examples are: transactions with related parties, product financing arrangements, firm purchase commitments, involuntary liquidation of LIFO inventories, and pledging of inventories as collateral. Inventories pledged as collateral for a loan should be presented in the current assets section rather than as an offset to the liability. The basis upon which inventory amounts are stated (lower of cost or market) and the method used in determining cost (LIFO, FIFO, average cost, etc.) should also be reported. For example, the annual report of Mumford of Wyoming contains the following disclosures.
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Presentation and Analysis N
MUMFORD OF WYOMING Note A: Significant Accounting Policies Live feeder cattle and feed--last-in, first-out (LIFO) cost, which is below approximate market Live range cattle--lower of principally identified cost or market Live sheep and supplies--lower of first-in, first-out (FIFO) cost or market Dressed meat and by-products--principally at market less allowances for distribution and selling expenses
Illustration 8-25 Disclosure of Inventory Methods
$854,800 $1,240,500 $674,000 $362,630
The preceding illustration shows that a company can use different pricing methods for different elements of its inventory. If Mumford changes the method of pricing any of its inventory elements, a change in accounting principle must be reported. For example, if Mumford changes its method of accounting for live sheep from FIFO to average cost, this change, along with the effect on income, should be separately reported in the financial statements. Changes in accounting principle require an explanatory paragraph in the auditor's report describing the change in method. Fortune Brands, Inc. reported its inventories in its Annual Report as follows (note the "trade practice" followed in classifying inventories among the current assets).
FORTUNE BRANDS, INC. Current assets Inventories (Note 2) Leaf tobacco Bulk whiskey Other raw materials, supplies and work in process Finished products
Illustration 8-26 Disclosure of Trade Practice in Valuing Inventories $ 563,424,000 232,759,000 238,906,000 658,326,000 1,693,415,000
Note 2: Inventories Inventories are priced at the lower of cost (average; first-in, first-out; and minor amounts at last-in, first-out) or market. In accordance with generally recognized trade practice, the leaf tobacco and bulk whiskey inventories are classified as current assets, although part of such inventories due to the duration of the aging process, ordinarily will not be sold within one year.
Analysis of Inventories
As illustrated in the opening story, the amount of inventory that a company carries can have significant economic consequences. As a result, inventories must be managed. But, inventory management is a double-edged sword that requires constant attention. On the one hand, management wants to have a great variety and quantity on hand so customers have the greatest selection and always find what they want in stock. However, such an inventory policy may incur excessive carrying costs (e.g., investment, storage, insurance, taxes, obsolescence, and damage). On the other hand, low inventory levels lead to stockouts, lost sales, and disgruntled customers. Financial ratios can be used to help chart a middle course between these two dangers. Common ratios used in the
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management and evaluation of inventory levels are inventory turnover and a related measure, average days to sell the inventory. The inventory turnover ratio measures the number of times on average the inventory was sold during the period. Its purpose is to measure the liquidity of the inventory. The inventory turnover is computed by dividing the cost of goods sold by the average inventory on hand during the period. Unless seasonal factors are significant, average inventory can be computed from the beginning and ending inventory balances. For example, in its 2001 annual report Kellogg Company reported a beginning inventory of $443.8 million, an ending inventory of $574.5 million, and cost of goods sold of $4,129 million for the year. The inventory turnover formula and Kellogg Company's 2001 ratio computation are shown below.
Illustration 8-27 Inventory Turnover Ratio
Cost of Goods Sold Average Inventory
$4,129 $574.5 + $443.8
= 8.1 times
A variant of the inventory turnover ratio is the average days to sell inventory. This measure represents the average number of days' sales for which inventory is on hand. For example, the inventory turnover for Kellogg Company of 8.1 times divided into 365 is approximately 45.1 days. There are typical levels of inventory in every industry. However, companies that are able to keep their inventory at lower levels with higher turnovers than those of their competitors, and still satisfy customer needs, are the most successful.
Summary of Learning Objectives
average cost method, 354 average days to sell inventory, 374 consigned goods, 350 cost flow assumptions, 353 designated market value, 369 dollar-value LIFO, 360 finished goods inventory, 346 first-in, first-out (FIFO) method, 355 f.o.b. destination, 350 f.o.b. shipping point, 350 inventories, 346 inventory turnover ratio, 374 last-in, first-out (LIFO) method, 356 LIFO effect, 357 LIFO liquidation, 358 LIFO reserve, 357
1 N Identify major classifications of inventory. Only one inventory account, Merchandise Inventory, appears in the financial statements of a merchandising concern. A manufacturer normally has three inventory accounts: Raw Materials, Work in Process, and Finished Goods. The cost assigned to goods and materials on hand but not yet placed into production is reported as raw materials inventory. The cost of the raw materials on which production has been started but not completed, plus the direct labor cost applied specifically to this material and a ratable share of manufacturing overhead costs, constitute the work in process inventory. The costs identified with the completed but unsold units on hand at the end of the fiscal period are reported as finished goods inventory. 2 Under a N Distinguish between perpetual and periodic inventory systems.maintained perpetual inventory system, a continuous record of changes in inventory is in the Inventory account. That is, all purchases and sales (issues) of goods are recorded directly in the Inventory account as they occur. Under a periodic inventory system, the quantity of inventory on hand is determined only periodically. The Inventory account remains the same and a Purchases account is debited. Cost of goods sold is determined at the end of the period using a formula. Ending inventory is ascertained by physical count. 3 should be as inventory diN Identify the items that bringing ofincludedto the place ofcost. Product costs areand rectly connected with the goods business of the buyer converting such goods to a salable condition. Such charges would include freight
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Review Exercise N charges on goods purchased, other direct costs of acquisition, and labor and other production costs incurred in processing the goods up to the time of sale. Manufacturing overhead costs are also allocated to inventory. These costs include indirect materials, indirect labor, and such items as depreciation, taxes, insurance, heat, and electricity incurred in the manufacturing process. 4 Describe and compare the flow assumptions used in accounting N Average cost prices items in cost inventory on the basis of the average for inventories. (1) the cost of all similar goods available during the period. (2) First-in, first-out (FIFO) assumes that goods are used in the order in which they are purchased. The inventory remaining must therefore represent the most recent purchases. (3) Last-in, first-out (LIFO) matches the cost of the last goods purchased against revenue. 5 The difference between the inN Explain the significance and use of a LIFO reserve.and LIFO is referred to as the Alventory method used for internal reporting purposes lowance to Reduce Inventory to LIFO, or the LIFO reserve. Either the LIFO reserve or the replacement cost of the inventory should be disclosed in the financial statements. 6 N Explain the effect of LIFO liquidations. The effect of LIFO liquidations is that costs from preceding periods are matched against sales revenues reported in current dollars. This leads to a distortion in net income and a substantial tax bill in the current period. LIFO liquidations can occur frequently when a specific goods LIFO approach is employed.
7 N Explain the dollar-value LIFO method. An important feature of the dollar-value LIFO method is that increases and decreases in a pool are determined and measured in terms of total dollar value, not the physical quantity of the goods in the inventory pool. 8 N Identify the major advantages and disadvantages of LIFO. The major advantages of LIFO are the following: (1) Recent costs are matched against current revenues to provide a better measure of current earnings. (2) As long as the price level increases and inventory quantities do not decrease, a deferral of income tax occurs in LIFO. (3) Because of the deferral of income tax, there is improvement of cash flow. Major disadvantages are: (1) reduced earnings, (2) understated inventory, and (3) no approximated physical flow of the items except in peculiar situations.
lower (floor) limit, 368 lower of cost or market (LCM), 368 market (for LCM), 367 merchandise inventory, 346 moving-average method, 355 net realizable value (NRV), 368 net realizable value less a normal profit margin, 368 period costs, 351 periodic inventory system, 348 perpetual inventory system, 347 product costs, 351 raw materials inventory, 346 specific goods pooled LIFO approach, 359 specific identification, 353 upper (ceiling) limit, 368 weighted-average method, 354 work in process inventory, 346
9 rule. If in value N Explain and apply the lower of cost or marketinventory inventory declines down to below its original cost for whatever reason, the should be written reflect this loss. The general rule is that the historical cost principle is abandoned when the future utility (revenue-producing ability) of the asset is no longer as great as its original cost. 10 and analyzed. N Explain how inventory is reportedthe composition Accounting standards require financial statement disclosure of: (1) of the inventory (in the balance sheet or a separate schedule in the notes); (2) significant or unusual inventory financing arrangements; and (3) inventory costing methods employed (which may differ for different elements of inventory). Accounting standards also require the consistent application of costing methods from one period to another. Common ratios used in the management and evaluation of inventory levels are inventory turnover and a related measure, average days to sell the inventory.
Norwel Company makes miniature circuit boards that are components of wireless phones and personal organizers. The company has experienced strong growth, and you are especially interested in how well Norwel is managing its inventory balances. You have collected the following information for the current year.
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Inventory at the beginning of year Inventory at the end of year, before any adjustments Total cost of goods sold, before any adjustments
$125.5 million $116.7 million $1,776.4 million
The company values inventory at lower of cost (using LIFO cost flow assumption) or market.
(a) Compute Norwel's inventory turnover ratio. (b) Recompute the inventory turnover ratio after adjusting Norwel's inventory information for the following items. 1. During the year, Norwel recorded sales and costs of goods sold on $2 million of units shipped to various wholesalers on consignment. At year-end, none of these units have been sold by wholesalers. 2. Shipping contracts changed 2 months ago from f.o.b. shipping point to f.o.b. destination point. At the end of the year, $5 million of products are en route to China (and will not arrive until after financial statements are released). Current inventory balances do not reflect this change in policy. 3. At the end of the year, a certain section of inventory with an historical cost of $12 million was determined to have a replacement cost of $10.8 million; net realizable value of $10.0 million; and net realizable value less a normal profit margin of $9.4 million. 4. To be more consistent with industry inventory valuation practices, Norwel changed from LIFO to FIFO for its inventory of high-speed circuit boards. This inventory is currently carried at $724 million (cost of goods sold, $941 million). Data for this item of inventory for the year are as follows.
January 1 April 10 October 20 November 20 December 15
Price per unit
100 250 120 370 220
130 250 150 3.50
Solution to Review Exercise
(a) $1,776.4 ($125.5 $116.7)/2 14.7 times
(b) Adjustments to ending inventory Adjustment to Ending Inventory ($000,000) $2 $5
Item 1. Consigned goods 2. Goods in transit
Explanation Norwel should count the goods it has consigned in other stores. Goods officially change hands at the point of destination. Norwel should still show these goods in inventory (no cost of goods sold), until they reach the destination.
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Review Exercise N
Adjustment to Ending Inventory ($000,000) $(2)
Item 3. Lower of cost or market
Explanation The correct valuation is $10.0 million since the market designation of $10.0 million is less than the original cost.
4. Change to FIFO
$46a $724 $770 $724)
Circuit board ending inventory under LIFO: Circuit board ending inventory under FIFO: 220 @ $3.50 Difference: $46 ($770 Adjusted inventory turnover ratio:
Cost of goods sold: $1,776.40 Ending inventory: $116.7 $2
$1,725.4b ($125.5 $167.7)c/2 11.8 times $2 $5 $2 $46 $1,725.40 $5 $2 $46 $167.7
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BEHIND THE NUMBERS
11 After studying
OB JECT IVE
Gross Profit Method
The basic purpose of taking a physical inventory is to verify the accuracy of the perpetual inventory records or, if no records exist, to arrive at an inventory amount. Sometimes, taking a physical inventory is impractical. In such cases, substitute measures are used to approximate inventory on hand. One substitute method of verifying or determining the inventory amount is called the gross profit method (also called the gross margin method).1 This method is widely used by auditors in situations where only an estimate of the company's inventory is needed (e.g., interim reports). It is also used where either inventory or inventory records have been destroyed by fire or other catastrophe. The gross profit method is based on three assumptions: (1) The beginning inventory plus purchases equal total goods to be accounted for. (2) Goods not sold must be on hand. And (3) if the sales, reduced to cost, are deducted from the sum of the opening inventory plus purchases, the result is the ending inventory. To illustrate, assume that Cetus Corp. has a beginning inventory of $60,000 and purchases of $200,000, both at cost. Sales at selling price amount to $280,000. The gross profit on selling price is 30 percent. The gross margin method is applied as follows.
Appendix 8A, you should be able to: Determine ending inventory by applying the gross profit method.
Illustration 8A-1 Application of Gross Profit Method
Beginning inventory (at cost) Purchases (at cost) Goods available (at cost) Sales (at selling price) Less: Gross profit (30% of $280,000) Sales (at cost) Approximate inventory (at cost) $280,000 84,000
$ 60,000 200,000 260,000
196,000 $ 64,000
All the information needed to compute Cetus's inventory at cost, except for the gross profit percentage, is available in the current period's records. The gross profit percentage is determined by reviewing company policies or prior period records. In some cases, this percentage must be adjusted if prior periods are not considered representative of the current period.2
An estimation method used in the retail industry, the retail method, is discussed in Appendix C at the end of the book. 2An alternative method of estimating inventory using the gross profit percentage, considered by some to be less complicated than the traditional method, uses the standard income statement format as follows. (Assume the same data as in the Cetus illustration above.)
Sales Cost of sales Beginning inventory Purchases Goods available for sale Ending inventory Cost of goods sold Gross profit on sales (30%) $280,000 $ 60,000 200,000 260,000 (3) ? (2) ? (1) ? $ 60,000 200,000 260,000 (3) 64,000 Est. (2)196,000 Est. (1) 84,000 Est. (footnote continues on next page) $280,000
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Computation of Gross Profit Percentage N
Computation of Gross Profit Percentage
In most situations, the gross profit percentage is given as a percentage of selling price. The previous illustration, for example, used a 30 percent gross profit on sales. Gross profit on selling price is the common method for quoting the profit for several reasons: (1) Most goods are stated on a retail basis, not a cost basis. (2) A profit quoted on selling price is lower than one based on cost, and this lower rate gives a favorable impression to the consumer. (3) The gross profit based on selling price can never exceed 100 percent.3 In Illustration 8A-1, the gross profit was a given. But how was that figure derived? To see how a gross profit percentage is computed, assume that an article cost $15 and sells for $20, a gross profit of $5. This markup is 1 4 or 25 percent of retail and 1 3 or 331 3 percent of cost.
25% at retail
331 3% on cost
Illustration 8A-2 Computation of Gross Profit Percentage
Although it is normal to compute the gross profit on the basis of selling price, you should understand the basic relationship between markup on cost and markup on selling price. For example, assume that you were told that the markup on cost for a given item is 25 percent. What, then, is the gross profit on selling price? To find the answer, assume that the selling price of the item is $1.00. In this case, the following formula applies.
Gross profit C .25C (1 .25)C 1.25C C
Selling price SP SP $1.00 $0.80
The gross profit equals $0.20 ($1.00 $0.80), and the rate of gross profit on selling price is therefore 20 percent ($0.20/$1.00). Conversely, assume that you were told that the gross profit on selling price is 20 percent. What is the markup on cost? To find the answer, again assume that the selling price is $1.00. Again, the same formula holds:
Compute the unknowns as follows: first the gross profit amount, then cost of goods sold, and then the ending inventory, as shown below. (1) $280,000 (2) $280,000 (3) $260,000
30% $84,000 (gross profit on sales). $84,000 $196,000 (cost of goods sold). $196,000 $64,000 (ending inventory).
The terms "gross margin percentage," "rate of gross profit," and "percentage markup" are synonymous, although "markup" is more commonly used in reference to cost and "gross profit" in reference to sales.
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N Chapter 8 Accounting for Inventories Cost Gross profit C .20SP C C C C Selling price SP (1 .20)SP .80SP .80($1.00) $0.80
Here, as in the previous example, the markup equals $0.20 ($1.00 $0.80), and the markup on cost is 25 percent ($0.20/$0.80). Retailers use the following formulas to express these relationships:
Illustration 8A-3 Formulas Relating to Gross Profit
1. Gross profit on selling price 2. Percentage markup on cost
Percentage markup on cost 100% 100% Percentage markup on cost Gross profit on selling price Gross profit on selling price
To understand how these formulas are employed, consider the following calculations.
Illustration 8A-4 Application of Gross Profit Formulas
Gross Profit on Selling Price
Given: 20% Given: 25% .25 1.00 .50 1.00 .50 .25 20% 331 3%
Percentage Markup on Cost
.20 1.00 .25 1.00 .25 .20 25% 331 3%
Given: 25% Given: 50%
Because selling price is greater than cost, and with the gross profit amount the same for both, gross profit on selling price will always be less than the related percentage based on cost. It should be emphasized that sales may not be multiplied by a costbased markup percentage; the gross profit percentage must be converted to a percentage based on selling price. Gross profits are closely followed by managements and analysts. A small change in the gross profit rate can have a significant effect on the bottom line. In 1993, Apple Computer suffered a textbook case of shrinking gross profits. In response to pricing wars in the personal computer market, Apple was forced to quickly reduce the price of its signature Macintosh computers--reducing prices more quickly than it could reduce its costs. As a result its gross profit rate fell from 44 percent in 1992 to 40 percent in 1993. Though the drop of 4 percent may appear small, its impact on the bottom line caused Apple's stock price to drop from $57 per share on June 1, 1993, to $27.50 by mid-July 1993. A similar effect (a 40 percent plummet in stock price) occurred when Woolworth Corp. disclosed a "correction of gross profits" due to a reporting of inaccurate gross profits in at least three of the company's quarterly reports during the fiscal year ended January 29, 1994.4
"Two Top Woolworth Officers Step Down Amid Probe of Accounting Irregularities," Wall Street Journal (April 4, 1994), p. A3.
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Evaluation of Gross Profit Method
What are the major disadvantages of the gross profit method? One major disadvantage is that it provides an estimate. As a result, a physical inventory must be taken once a year to verify the inventory that is actually on hand. Second, the gross profit method uses past percentages in determining the markup. Although the past can often provide answers to the future, a current rate is more appropriate. It is important to emphasize that whenever significant fluctuations occur, the percentage should be adjusted as appropriate. Third, care must be taken in applying a blanket gross profit rate. Frequently, a store or department handles merchandise with widely varying rates of gross profit. In these situations, the gross profit method may have to be applied by subsections, lines of merchandise, or a similar basis that classifies merchandise according to their respective rates of gross profit. The gross profit method is not normally acceptable for financial reporting purposes because it provides only an estimate. A physical inventory is needed as additional verification that the inventory indicated in the records is actually on hand. Nevertheless, the gross profit method is permitted to determine ending inventory for interim (generally quarterly) reporting purposes, provided the use of this method is disclosed. Note that the gross profit method will follow closely the inventory method used (FIFO, LIFO, average cost) because it is based on historical records.
Summary of Learning Objective for Appendix 8A
11 the gross profit method. N Determine ending inventory by applyingthe gross profit method areThe steps to determine ending inventory by applying as follows: (1) Compute the gross profit percentage on selling price. (2) Compute gross profit by multiplying net sales by the gross profit percentage. (3) Compute cost of goods sold by subtracting gross profit from net sales. (4) Compute ending inventory by subtracting cost of goods sold from total goods available for sale. Note: All asterisked Questions, Brief Exercises, Exercises, Problems, and Conceptual Cases relate to material covered in the appendix to the chapter.
gross profit method, 378 gross profit percentage, 379
1 In what ways are the inventory accounts of a retailing concern different from those of a manufacturing enterprise? 2 Why should inventories be included in (a) a statement of financial position and (b) the computation of net income? 3 What is the difference between a perpetual inventory and a physical inventory? If a company maintains a perpetual inventory, should its physical inventory at any date be equal to the amount indicated by the perpetual inventory records? Why? 4 Mariah Carey Inc. indicated in a recent annual report that approximately $19 million of merchandise was received on consignment. Should Mariah Carey Inc. report this amount on its balance sheet? Explain. 5 Where, if at all, should the following items be classified on a balance sheet? (a) Goods out on approval to customers. (b) Goods in transit that were recently purchased f.o.b. destination. (c) Land held by a realty firm for sale. (d) Raw materials. (e) Goods received on consignment. (f) Manufacturing supplies. 6 Define "cost" as applied to the valuation of inventories. 7 Specific identification is sometimes said to be the ideal method of assigning cost to inventory and to cost of goods sold. Briefly indicate the arguments for and against this method of inventory valuation. 8 First-in, first-out; weighted average; and last-in, first-out methods are often used instead of specific identification for inventory valuation purposes. Compare these methods with the specific identification method, discussing the theoretical propriety of each method in the determination of income and asset valuation. 9 As compared with the FIFO method of costing inventories, does the LIFO method result in a larger or smaller net income in a period of rising prices? What is the comparative effect on net income in a period of falling prices? 10 What is the dollar-value method of LIFO inventory valuation? What advantage does the dollar-value method
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N Chapter 8 Accounting for Inventories mine the proper unit inventory price in the following cases.
Cost $15.90 Net realizable value 14.30 Net realizable value less normal profit 12.80 Market (replacement cost) 14.80
have over the specific goods approach of LIFO inventory valuation? Why will the traditional LIFO inventory costing method and the dollar-value LIFO inventory costing method produce different inventory valuations if the composition of the inventory base changes? 11 Explain the following terms: (a) LIFO layer. (b) LIFO reserve. (c) LIFO effect. 12 On December 31, 2003, the inventory of Mario Lemieux Company amounts to $800,000. During 2004, the company decides to use the dollar-value LIFO method of costing inventories. On December 31, 2004, the inventory is $1,026,000 at December 31, 2004, prices. Using the December 31, 2003, price level of 100 and the December 31, 2004, price level of 108, compute the inventory value at December 31, 2004, under the dollar-value LIFO method. 13 In an article that appeared in the Wall Street Journal, the phrases "phantom (paper) profits" and "high LIFO profits" through involuntary liquidation were used. Explain these phrases. 14 Where there is evidence that the utility of inventory goods, as part of their disposal in the ordinary course of business, will be less than cost, what is the proper accounting treatment? 15 Explain the rationale for the ceiling and floor in the lower of cost or market method of valuing inventories. 16 What approaches may be employed in applying the lower of cost or market procedure? Which approach is normally used and why? 17 In some instances accounting principles require a departure from valuing inventories at cost alone. Deter-
$16.10 19.20 17.60 17.20
$15.90 15.20 13.75 12.80
$15.90 10.40 8.80 9.70
$15.90 16.40 14.80 16.80
18 Bodeans Company reported inventory in its balance sheet as follows:
What additional disclosures might be necessary to present the inventory fairly? 19 Of what significance is inventory turnover to a retail store? *20 What are the major uses of the gross profit method? *21 A fire destroys all of the merchandise of Rosanna Arquette Company on February 10, 2004. Presented below is information compiled up to the date of the fire.
Inventory, January 1, 2004 Sales to February 10, 2004 Purchases to February 10, 2004 Freight-in to February 10, 2004 Rate of gross profit on selling price $ 400,000 1,750,000 1,140,000 60,000 40%
What is the approximate inventory on February 10, 2004?
BE8-1 Included in the December 31 trial balance of Billie Joel Company are the following assets.
Cash Equipment (net) Prepaid insurance Raw materials $ 190,000 1,100,000 41,000 335,000 Work in process Receivables (net) Patents Finished goods $200,000 400,000 110,000 150,000
Prepare the current assets section of the December 31 balance sheet. BE8-2 Alanis Morrissette Company uses a perpetual inventory system. Its beginning inventory consists of 50 units that cost $30 each. During June, the company purchased 150 units at $30 each, returned 6 units for credit, and sold 125 units at $50 each. Journalize the June transactions. BE8-3 Mayberry Company took a physical inventory on December 31 and determined that goods costing $200,000 were on hand. Not included in the physical count were $15,000 of goods purchased from Taylor Corporation, f.o.b. shipping point; and $22,000 of goods sold to Mount Pilot Company for $30,000, f.o.b. destination. Both the Taylor purchase and the Mount Pilot sale were in transit at year-end. What amount should Mayberry report as its December 31 inventory?
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Brief Exercises N
BE8-4 Jose Zorilla Company uses a periodic inventory system. For April, when the company sold 700 units, the following information is available.
April 1 inventory April 15 purchase April 23 purchase 250 400 350 1,000
$10 12 13
$ 2,500 4,800 4,550 $11,850
Compute the April 30 inventory and the April cost of goods sold using the average cost method. BE8-5 Data for Jose Zorilla Company are presented in BE8-4. Compute the April 30 inventory and the April cost of goods sold using the FIFO method. BE8-6 Data for Jose Zorilla Company are presented in BE8-4. Compute the April 30 inventory and the April cost of goods sold using the LIFO method. BE8-7 Easy-E Company had ending inventory at end-of-year prices of $100,000 at December 31, 2002; $123,200 at December 31, 2003; and $134,560 at December 31, 2004. The year-end price indexes were 100 for 2002; 110 for 2003; and 116 for 2004. Compute the ending inventory for Easy-E Company for 2002 through 2004 using the dollar-value LIFO method. BE8-8 Wingers uses the dollar-value LIFO method of computing its inventory. Data for the past 3 years follow. Compute the value of the 2002 and 2003 inventories using the dollar-value LIFO method.
Year Ended December 31
2001 2002 2003
Inventory at Current-year Cost
$19,750 21,708 25,935
100 108 114
Presented below is information related to Alstott Inc.'s inventory.
Historical cost Selling price Cost to distribute Current replacement cost Normal profit margin
$190.00 217.00 19.00 203.00 32.00
$106.00 145.00 8.00 105.00 29.00
$53.00 73.75 2.50 51.00 21.25
Determine the following: (a) the two limits to market value (i.e., the ceiling and the floor) that should be used in the lower of cost or market computation for skis; (b) the cost amount that should be used in the lower of cost or market comparison of boots; and (c) the market amount that should be used to value parkas on the basis of the lower of cost or market. BE8-10 Robin Corporation has the following four items in its ending inventory.
$1,900 5,100 4,550 2,990
Jokers Penguins Riddlers Scarecrows
$2,000 5,000 4,400 3,200
Net Realizable Value (NRV)
$2,100 4,950 4,625 3,830
NRV Less Normal Profit Margin
$1,600 4,100 3,700 3,070
Determine the final lower of cost of market inventory value for each item. BE8-11 In its 2000 Annual Report, Deere and Company reported inventory of $1,552.9 million on October 31, 2000, and $1,294.3 million on October 31, 1999, cost of goods sold of $8,936.1 million for fiscal year 2000,
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N Chapter 8 Accounting for Inventories and net sales of $11,168.6 million. Compute Deere and Company's inventory turnover and the average days to sell inventory for the fiscal year 2000. *BE8-12 Big Hurt Corporation's April 30 inventory was destroyed by fire. January 1 inventory was $150,000, and purchases for January through April totaled $500,000. Sales for the same period were $700,000. Big Hurt's normal gross profit percentage is 31%. Using the gross profit method, estimate Big Hurt's April 30 inventory that was destroyed by fire.
E8-1 (Inventoriable Costs) Presented below is a list of items that may or may not be reported as inventory in a company's December 31 balance sheet. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. Goods out on consignment at another company's store. Goods sold on an installment basis. Goods purchased f.o.b. shipping point that are in transit at December 31. Goods purchased f.o.b. destination that are in transit at December 31. Goods sold to another company, for which our company has signed an agreement to repurchase at a set price that covers all costs related to the inventory. Goods sold f.o.b. shipping point that are in transit at December 31. Freight charges on goods purchased. Factory labor costs incurred on goods still unsold. Interest costs incurred for inventories that are routinely manufactured. Costs incurred to advertise goods held for resale. Materials on hand not yet placed into production by a manufacturing firm. Office supplies. Raw materials on which a manufacturing firm has started production, but which are not completely processed. Factory supplies. Goods held on consignment from another company. Costs identified with units completed by a manufacturing firm, but not yet sold. Goods sold f.o.b. destination that are in transit at December 31. Temporary investments in stocks and bonds that will be resold in the near future.
Indicate which of these items would typically be reported as inventory in the financial statements. If an item should not be reported as inventory, indicate how it should be reported in the financial statements. E8-2 (Inventoriable Costs) In your audit of Jose Oliva Company, you find that a physical inventory on December 31, 2002, showed merchandise with a cost of $441,000 was on hand at that date. You also discover the following items were all excluded from the $441,000. 1. 2. 3. 4. 5. Merchandise of $61,000 which is held by Oliva on consignment. The consignor is the Max Suzuki Company. Merchandise costing $38,000 which was shipped by Oliva f.o.b. destination to a customer on December 31, 2002. The customer was expected to receive the merchandise on January 6, 2003. Merchandise costing $46,000 which was shipped by Oliva f.o.b. shipping point to a customer on December 29, 2002. The customer was scheduled to receive the merchandise on January 2, 2003. Merchandise costing $83,000 shipped by a vendor f.o.b. destination on December 30, 2002, and received by Oliva on January 4, 2003. Merchandise costing $51,000 shipped by a vendor f.o.b. seller on December 31, 2002, and received by Oliva on January 5, 2003.
Based on the above information, calculate the amount that should appear on Oliva's balance sheet at December 31, 2002, for inventory.
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E8-3 (Inventoriable Costs) In an annual audit of Jan Matejko Company at December 31, 2004, you find the following transactions near the closing date. 1. A special machine, fabricated to order for a customer, was finished and specifically segregated in the back part of the shipping room on December 31, 2004. The customer was billed on that date and the machine excluded from inventory although it was shipped on January 4, 2005. Merchandise costing $2,800 was received on January 3, 2005, and the related purchase invoice recorded January 5. The invoice showed the shipment was made on December 29, 2004, f.o.b. destination. A packing case containing a product costing $3,400 was standing in the shipping room when the physical inventory was taken. It was not included in the inventory because it was marked "Hold for shipping instructions." Your investigation revealed that the customer's order was dated December 18, 2004, but that the case was shipped and the customer billed on January 10, 2005. The product was a stock item of your client. Merchandise received on January 6, 2005, costing $680 was entered in the purchase journal on January 7, 2005. The invoice showed shipment was made f.o.b. supplier's warehouse on December 31, 2004. Because it was not on hand at December 31, it was not included in inventory. Merchandise costing $720 was received on December 28, 2004, and the invoice was not recorded. You located it in the hands of the purchasing agent; it was marked "on consignment."
Assuming that each of the amounts is material, state whether the merchandise should be included in the client's inventory. Give your reason for your decision on each item. E8-4 (Inventoriable Costs--Perpetual) Colin Davis Machine Company maintains a general ledger account for each class of inventory, debiting such accounts for increases during the period and crediting them for decreases. The transactions below relate to the Raw Materials inventory account, which is debited for materials purchased and credited for materials requisitioned for use. 1. 2. 3. An invoice for $8,100, terms f.o.b. destination, was received and entered January 2, 2004. The receiving report shows that the materials were received December 28, 2003. Materials costing $28,000, shipped f.o.b. destination, were not entered by December 31, 2003, "because they were in a railroad car on the company's siding on that date and had not been unloaded." Materials costing $7,300 were returned to the creditor on December 29, 2003, and were shipped f.o.b. shipping point. The return was entered on that date, even though the materials are not expected to reach the creditor's place of business until January 6, 2004. An invoice for $7,500, terms f.o.b. shipping point, was received and entered December 30, 2003. The receiving report shows that the materials were received January 4, 2004, and the bill of lading shows that they were shipped January 2, 2004. Materials costing $19,800 were received December 30, 2003, but no entry was made for them because "they were ordered with a specified delivery of no earlier than January 10, 2004."
Prepare correcting general journal entries required at December 31, 2003, assuming that the books have not been closed. E8-5 (Determining Merchandise Amounts--Periodic) Two or more items are omitted in each of the following tabulations of income statement data. Fill in the amounts that are missing.
Sales Sales returns Net sales Beginning inventory Ending inventory Purchases Purchase returns and allowances Transportation-in Cost of goods sold Gross profit on sales $290,000 11,000 ? 20,000 ? ? 5,000 8,000 233,000 46,000
$ ? 13,000 347,000 32,000 ? 260,000 8,000 9,000 ? 91,000
$410,000 ? ? ? ? 298,000 10,000 12,000 293,000 97,000
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N Chapter 8 Accounting for Inventories E8-6 (Financial Statement Presentation of Manufacturing Amounts--Periodic) Navajo Company is a manufacturing firm. Presented below is selected information from its 2003 accounting records.
Raw materials inventory, 1/1/03 Raw materials inventory, 12/31/03 Work in process inventory, 1/1/03 Work in process inventory, 12/31/03 Finished goods inventory, 1/1/03 Finished goods inventory, 12/31/03 Purchases Transportation-in $ 30,800 37,400 72,600 61,600 35,200 22,000 278,600 6,600 Transportation-out Selling expenses Administrative expenses Purchase discounts Purchase returns and allowances Interest expense Direct labor Manufacturing overhead $ 8,000 300,000 180,000 10,640 6,460 15,000 440,000 330,000
(a) (b) (c) (d) Compute raw materials used. Compute the cost of goods manufactured. Compute cost of goods sold. Indicate how inventories would be reported in the December 31, 2003, balance sheet.
E8-7 (Periodic versus Perpetual Entries) The Fong Sai-Yuk Company sells one product. Presented below is information for January for the Fong Sai-Yuk Company.
Jan. 2 4 11 13 20 27 Inventory Sale Purchase Sale Purchase Sale 100 units at $5 each 80 units at $8 each 150 units at $6 each 120 units at $8.75 each 160 units at $7 each 100 units at $9 each
Fong Sai-Yuk uses the FIFO cost flow assumption. All purchases and sales are on account.
(a) Assume Fong Sai-Yuk uses a periodic system. Prepare all necessary journal entries, including the endof-month closing entry to record cost of goods sold. A physical count indicates that the ending inventory for January is 110 units. (b) Compute gross profit using the periodic system. (c) Assume Fong Sai-Yuk uses a perpetual system. Prepare all necessary journal entries. (d) Compute gross profit using the perpetual system.
E8-8 (FIFO and LIFO--Periodic and Perpetual) Inventory information for Part 311 of Monique Aaron Corp. discloses the following information for the month of June.
June 1 Balance 11 Purchased 20 Purchased 300 units @ $10 800 units @ $12 500 units @ $13 June 10 Sold 15 Sold 27 Sold 200 units @ $24 500 units @ $25 300 units @ $27
(a) Assuming that the periodic inventory method is used, compute the cost of goods sold and ending inventory under (1) LIFO and (2) FIFO. (b) Assuming that the perpetual inventory record is kept in dollars and costs are computed at the time of each withdrawal, what is the value of the ending inventory at LIFO? (c) Assuming that the perpetual inventory record is kept in dollars and costs are computed at the time of each withdrawal, what is the gross profit if the inventory is valued at FIFO? (d) Why is it stated that LIFO usually produces a lower gross profit than FIFO?
E8-9 (FIFO, LIFO and Average Cost Determination) John Adams Company's record of transactions for the month of April was as follows.
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April 1 (balance on hand) 4 8 13 21 29 600 1,500 800 1,200 700 500 5,300 @ @ @ @ @ @ $6.00 6.08 6.40 6.50 6.60 6.79 April 3 9 11 23 27
500 1,400 600 1,200 900 4,600 @ @ @ @ @ $10.00 10.00 11.00 11.00 12.00
(a) Assuming that perpetual inventory records are kept in units only, compute the inventory at April 30 using (1) LIFO and (2) average cost. (b) Assuming that perpetual inventory records are kept in dollars, determine the inventory using (1) FIFO and (2) LIFO. (c) Compute cost of goods sold assuming periodic inventory procedures and inventory priced at FIFO. (d) In an inflationary period, which inventory method--FIFO, LIFO, average cost--will show the highest net income? E8-10 (FIFO, LIFO, Average Cost Inventory) Shania Twain Company was formed on December 1, 2002. The following information is available from Twain's inventory records for Product BAP.
January 1, 2003 (beginning inventory) Purchases in 2003 January 5 January 25 February 16 March 26 600 1,200 1,300 800 600
$ 8.00 9.00 10.00 11.00 12.00
A physical inventory on March 31, 2003, shows 1,600 units on hand.
Prepare schedules to compute the ending inventory at March 31, 2003, under each of the following inventory methods. (a) FIFO. (b) LIFO. (c) Weighted average.
E8-11 (Compute FIFO, LIFO, Average Cost--Periodic) Presented below is information related to Blowfish radios for Hootie Company for the month of July.
July 1 6 7 10 12 15 18 22 25 30
Balance Purchase Sale Sale Purchase Sale Purchase Sale Purchase Sale Totals
$ 410 3,360
300 300 400 300 500 2,100 4.50 4.60 4.58 1,800 200 1,380 400 2,290 200 $9,240 1,400
$7.00 7.30 7.40 7.40 7.50
$ 2,100 2,190 1,480 2,960 1,500 $10,230
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(a) Assuming that the periodic inventory method is used, compute the inventory cost at July 31 under each of the following cost flow assumptions. (1) FIFO. (2) LIFO. (3) Weighted-average. (Round the weighted-average unit cost to the nearest one-tenth of one cent.) (b) Answer the following questions. (1) Which of the methods used above will yield the lowest figure for gross profit for the income statement? Explain why. (2) Which of the methods used above will yield the lowest figure for ending inventory for the balance sheet? Explain why.
E8-12 (FIFO and LIFO--Periodic and Perpetual) The following is a record of Pervis Ellison Company's transactions for Boston teapots for the month of May 2004.
May 1 12 28
Balance 400 units @ $20 Purchase 600 units @ $25 Purchase 400 units @ $30
May 10 20
Sale 300 units @ $38 Sale 540 units @ $38
(a) Assuming that perpetual inventories are not maintained and that a physical count at the end of the month shows 560 units on hand, what is the cost of the ending inventory using (1) FIFO and (2) LIFO? (b) Assuming that perpetual records are maintained and they tie into the general ledger, calculate the ending inventory using (1) FIFO and (2) LIFO.
E8-13 (FIFO and LIFO; Income Statement Presentation) The board of directors of Deion Sanders Corporation is considering whether or not it should instruct the accounting department to shift from a first-in, first-out (FIFO) basis of pricing inventories to a last-in, first-out (LIFO) basis. The following information is available.
Sales Inventory, January 1 Purchases 21,000 6,000 6,000 10,000 7,000 8,000 $200,000 units units units units units units @ @ @ @ @ @ $50 20 22 25 30 ?
Inventory, December 31 Operating expenses
Prepare a condensed income statement for the year on both bases for comparative purposes.
E8-14 (FIFO and LIFO Effects) You are the vice-president of finance of Sandy Alomar Corporation, a retail company. The company prepared two different schedules of gross margin for the first quarter ended March 31, 2004. These schedules appear below.
Sales ($5 per unit)
Schedule 1 Schedule 2 $150,000 150,000
Cost of Goods Sold
The computation of cost of goods sold in each schedule is based on the following data.
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Cost per Unit
$4.00 4.20 4.25 4.30 4.40
Beginning inventory, January 1 Purchase, January 10 Purchase, January 30 Purchase, February 11 Purchase, March 17 10,000 8,000 6,000 9,000 11,000
$40,000 33,600 25,500 38,700 48,400
Jane Torville, the president of the corporation, cannot understand how two different gross margins can be computed from the same set of data. As the vice-president of finance you have explained to Ms. Torville that the two schedules are based on different assumptions concerning the flow of inventory costs, i.e., first-in, first-out, and last-in, first-out. Schedules 1 and 2 were not necessarily prepared in this sequence of cost flow assumptions.
Prepare two separate schedules computing cost of goods sold and supporting schedules showing the composition of the ending inventory under both cost flow assumptions. E8-15 (FIFO and LIFO--Periodic) Howie Long Shop began operations on January 2, 2004. The following stock record card for footballs was taken from the records at the end of the year.
1/15 3/15 6/20 9/12 11/24
10624 11437 21332 27644 31269 Totals
Net 30 1/5, net 30 1/10, net 30 1/10, net 30 1/10, net 30
50 65 90 84 76 365
Unit Invoice Cost
$20.00 16.00 15.00 12.00 11.00
Gross Invoice Amount
$1,000.00 1,040.00 1,350.00 1,008.00 836.00 $5,234.00
A physical inventory on December 31, 2004, reveals that 100 footballs were in stock. The bookkeeper informs you that all the discounts were taken. Assume that Howie Long Shop uses the invoice price less discount for recording purchases.
(a) Compute the December 31, 2004, inventory using the FIFO method. (b) Compute the 2004 cost of goods sold using the LIFO method. (c) What method would you recommend to the owner to minimize income taxes in 2004, using the inventory information for footballs as a guide? E8-16 (LIFO Effect) The following example was provided to encourage the use of the LIFO method.
In a nutshell, LIFO subtracts inflation from inventory costs, deducts it from taxable income, and records it in a LIFO reserve account on the books. The LIFO benefit grows as inflation widens the gap between current-year and past-year (minus inflation) inventory costs. This gap is:
Revenue Cost of goods sold Operating expenses Operating income LIFO adjustment Taxable income Income taxes @ 36% Cash flow Extra cash Increased cash flow $3,200,000 2,800,000 150,000 250,000 40,000 $210,000 $ 75,600 $174,400 $ 14,400 9%
$3,200,000 2,800,000 150,000 250,000 0 $250,000 $ 90,000 $160,000 0 0%
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(a) Explain what is meant by the LIFO reserve account. (b) How does LIFO subtract inflation from inventory costs? (c) Explain how the cash flow of $174,400 in this example was computed. Explain why this amount may not be correct. (d) Why does a company that uses LIFO have extra cash? Explain whether this situation will always exist.
E8-17 (Alternative Inventory Methods--Comprehensive) Tori Amos Corporation began operations on December 1, 2003. The only inventory transaction in 2003 was the purchase of inventory on December 10, 2003, at a cost of $20 per unit. None of this inventory was sold in 2003. Relevant information is as follows.
Ending inventory units December 31, 2003 December 31, 2004, by purchase date December 2, 2004 July 20, 2004
100 100 50
During the year the following purchases and sales were made.
March 15 July 20 September 4 December 2 300 300 200 100 units units units units at at at at $24 25 28 30
April 10 August 20 November 18 December 12 200 300 150 200
The company uses the periodic inventory method.
(a) Determine ending inventory under (1) specific identification, (2) FIFO, (3) LIFO periodic, and (4) average cost. (b) Determine ending inventory using dollar-value LIFO. Assume that the December 2, 2004, purchase cost is the current cost of inventory (Hint: The beginning inventory is the base layer priced at $20 per unit; the relevant price index is 1.4667.).
E8-18 (Dollar-Value LIFO) Oasis Company has used the dollar-value LIFO method for inventory cost determination for many years. The following data were extracted from Oasis's records.
December 31, 2002 December 31, 2003
Ending Inventory at Base Prices
Ending Inventory at Dollar-Value LIFO
Calculate the index used for 2003 that yielded the above results.
E8-19 (Dollar-Value LIFO) The dollar-value LIFO method was adopted by Enya Corp. on January 1, 2004. Its inventory on that date was $160,000. On December 31, 2004, the inventory at prices existing on that date amounted to $140,000. The price level at January 1, 2004, was 100, and the price level at December 31, 2004, was 112.
(a) Compute the amount of the inventory at December 31, 2004, under the dollar-value LIFO method. (b) On December 31, 2005, the inventory at prices existing on that date was $172,500, and the price level was 115. Compute the inventory on that date under the dollar-value LIFO method.
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E8-20 (Dollar-Value LIFO) Presented below is information related to Dino Radja Company.
Ending Inventory (End-of-Year Prices)
2001 2002 2003 2004 2005 2006 $ 80,000 115,500 108,000 122,200 154,000 176,900
December December December December December December 31, 31, 31, 31, 31, 31,
100 105 120 130 140 145
Compute the ending inventory for Dino Radja Company for 2001 through 2006 using the dollar-value LIFO method.
E8-21 (Lower of Cost or Market) items.
The inventory of 3T Company on December 31, 2004, consists of these
110 111 112 113 120 121a 122
600 1,000 500 200 400 1,600 300
Cost per Unit
$ 90 60 80 170 205 16 240
Cost to Replace per Unit
$100 52 76 180 208 14 235
Part No. 121 is obsolete and has a realizable value of $0.20 each as scrap.
(a) Determine the inventory as of December 31, 2004, by the lower of cost or market method, applying this method directly to each item. (b) Determine the inventory by the lower of cost or market method, applying the method to the total of the inventory.
E8-22 (Lower of Cost or Market) Smashing Pumpkins Company uses the lower of cost or market method, on an individual-item basis, in pricing its inventory items. The inventory at December 31, 2004, consists of products D, E, F, G, H, and I. Relevant per-unit data for these products appear below.
Estimated selling price Cost Replacement cost Estimated selling expense Normal profit $120 75 120 30 20
$110 80 72 30 20
$95 80 70 30 20
$90 80 30 25 20
$110 50 70 30 20
$90 36 30 30 20
Using the lower of cost or market rule, determine the proper unit value for balance sheet reporting purposes at December 31, 2004, for each of the inventory items above.
E8-23 (Lower of Cost or Market) Michael Bolton Company follows the practice of pricing its inventory at the lower of cost or market, on an individual-item basis.
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1320 1333 1426 1437 1510 1522 1573 1626
1,200 900 800 1,000 700 500 3,000 1,000
Cost per Unit
$3.20 2.70 4.50 3.60 2.25 3.00 1.80 4.70
Cost to Replace
$3.00 2.30 3.70 3.10 2.00 2.70 1.60 5.20
Estimated Selling Price
$4.50 3.50 5.00 3.20 3.25 3.80 2.50 6.00
Cost of Completion and Disposal
$.35 .50 .40 .25 .80 .40 .75 .50
$1.25 .50 1.00 .90 .60 .50 .50 1.00
From the information above, determine the amount of Bolton Company inventory. E8-24 (Analysis of Inventories) The financial statements of General Mills, Inc's. 2000 Annual Report disclose the following information.
May 28, 2000
May 30, 1999
May 31, 1998
Fiscal Year 2000
Sales Cost of goods sold Net income $6,700.2 2,697.6 614.4
$6,246.1 2,593.1 534.5
Compute General Mills' (a) inventory turnover, and (b) the average days to sell inventory for 2000 and 1999. *E8-25 (Gross Profit Method) Rasheed Wallace Company lost most of its inventory in a fire in December just before the year-end physical inventory was taken. The corporation's books disclosed the following.
Beginning inventory Purchases for the year Purchase returns $170,000 390,000 30,000 Sales Sales returns Rate of gross margin on sales $650,000 24,000 40%
Merchandise with a selling price of $21,000 remained undamaged after the fire. Damaged merchandise with an original selling price of $15,000 had a net realizable value of $5,300.
Compute the amount of the loss as a result of the fire, assuming that the corporation had no insurance coverage.
P8-1 (Various Inventory Issues) The following independent situations relate to inventory accounting. 1. 2. Jag Co. purchased goods with a list price of $150,000, subject to trade discounts of 20% and 10% with no cash discounts allowable. How much should Jag Co. record as the cost of these goods? Francis Company's inventory of $1,100,000 at December 31, 2003, was based on a physical count of goods priced at cost and before any year-end adjustments relating to the following items. a. Goods shipped f.o.b. shipping point on December 24, 2003, from a vendor at an invoice cost of $69,000 to Francis Company were received on January 4, 2004. b. The physical count included $29,000 of goods billed to Sakic Corp. f.o.b. shipping point on December 31, 2003. The carrier picked up these goods on January 3, 2004. What amount should Francis report as inventory on its balance sheet?
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3. Mark Messier Corp. had 1,500 units of part M.O. on hand May 1, 2003, costing $21 each. Purchases of part M.O. during May were as follows.
May 9 17 26 2,000 3,500 1,000
$22.00 23.00 24.00
A physical count on May 31, 2003, shows 2,100 units of part M.O. on hand. Using the FIFO method, what is the cost of part M.O. inventory at May 31, 2003? Using the LIFO method, what is the inventory cost? Using the average cost method, what is the inventory cost? Forsberg Company adopted the dollar-value LIFO method on January 1, 2003 (using internal price indexes and multiple pools). The following data are available for inventory pool A for the 2 years following adoption of LIFO.
At BaseYear Cost
$200,000 240,000 256,000
1/1/03 12/31/03 12/31/04
At CurrentYear Cost
$200,000 252,000 286,720
100 105 112
Using the dollar-value LIFO method, at what amount should the inventory be reported at December 31, 2004? Eric Lindros Inc., a retail store chain, had the following information in its general ledger for the year 2004.
Merchandise purchased for resale Interest on notes payable to vendors Purchase returns Freight-in Freight-out $909,400 8,700 16,500 22,000 17,100
What is Lindros' inventoriable cost for 2004?
Answer each of the questions above about inventories and explain your answers. P8-2 (Compute FIFO, LIFO, and Average Cost--Periodic and Perpetual) Taos Company's record of transactions concerning part X for the month of April was as follows.
April 1 (balance on hand) 4 11 18 26 30 100 400 300 200 500 200 @ @ @ @ @ @ $5.00 5.10 5.30 5.35 5.60 5.80 April
5 12 27 28 300 200 800 100
(a) Compute the inventory at April 30 on each of the following bases. Assume that perpetual inventory records are kept in units only. Carry unit costs to the nearest cent. (1) First-in, first-out (FIFO). (2) Last-in, first-out (LIFO). (3) Average cost. (b) If the perpetual inventory record is kept in dollars, and costs are computed at the time of each withdrawal, what amount would be shown as ending inventory in 1, 2, and 3 above? Carry average unit costs to four decimal places.
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N Chapter 8 Accounting for Inventories P8-3 (Compute FIFO, LIFO and Average Cost--Periodic and Perpetual) Some of the information found on a detail inventory card for David Letterman Inc. for the first month of operations is as follows.
January 2 7 10 13 18 20 23 26 28 31
No. of Units
1,200 600 1,000 1,300 1,500
Issued, No. of Units
Balance, No. of Units
1,200 500 1,100 600 1,300 200 1,500 700 2,200 900
3.20 3.30 3.40 800 3.60 1,300 500 300 1,100
(a) From these data compute the ending inventory on each of the following bases. Assume that perpetual inventory records are kept in units only. Carry unit costs to the nearest cent and ending inventory to the nearest dollar. (1) First-in, first-out (FIFO). (2) Last-in, first-out (LIFO). (3) Average cost. (b) If the perpetual inventory record is kept in dollars, and costs are computed at the time of each withdrawal, would the amounts shown as ending inventory in 1, 2, and 3 above be the same? Explain and compute. P8-4 (Compute FIFO, LIFO, Average Cost--Periodic and Perpetual) Iowa Company is a multi-product firm. Presented below is information concerning one of its products, the Hawkeye.
1/1 2/4 2/20 4/2 11/4
Beginning inventory Purchase Sale Purchase Sale
1,000 2,000 2,500 3,000 2,000
$12 18 30 23 33
Compute cost of goods sold, assuming Iowa uses: (a) (b) (c) (d) (e) (f) Periodic system, FIFO cost flow. Perpetual system, FIFO cost flow. Periodic system, LIFO cost flow. Perpetual system, LIFO cost flow. Periodic system, weighted-average cost flow. Perpetual system, moving-average cost flow.
P8-5 (Financial Statement Effects of FIFO and LIFO) The management of Maine Company has asked its accounting department to describe the effect upon the company's financial position and its income statements of accounting for inventories on the LIFO rather than the FIFO basis during 2004 and 2005. The accounting department is to assume that the change to LIFO would have been effective on January 1, 2004, and that the initial LIFO base would have been the inventory value on December 31, 2003. Presented below are the company's financial statements and other data for the years 2004 and 2005 when the FIFO method was employed.
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Financial Position as of 12/31/03
Cash Accounts receivable Inventory Other assets Total assets Accounts payable Other liabilities Common stock Retained earnings Total equities $ 90,000 80,000 120,000 160,000 $450,000 $ 40,000 70,000 200,000 140,000 $450,000
$130,000 100,000 140,000 170,000 $540,000 $ 60,000 80,000 200,000 200,000 $540,000
$ 141,600 120,000 180,000 200,000 $ 641,600 $ 80,000 110,000 200,000 251,600
Income for Years Ended 12/31/04
Sales Less: Cost of goods sold Other expenses $900,000 505,000 205,000 710,000 Net income before income taxes Income taxes (40%) Net income 190,000 76,000 $114,000
$1,350,000 770,000 304,000 1,074,000 276,000 110,400 $ 165,600
Other data: 1. 2. Inventory on hand at 12/31/03 consisted of 40,000 units valued at $3.00 each. Sales (all units sold at the same price in a given year):
2004--150,000 units @ $6.00 each 2005--180,000 units @ $7.50 each
Purchases (all units purchased at the same price in given year):
2004--150,000 units @ $3.50 each 2005--180,000 units @ $4.50 each
Income taxes at the effective rate of 40% are paid on December 31 each year.
Name the account(s) presented in the financial statements that would have different amounts for 2005 if LIFO rather than FIFO had been used, and state the new amount for each account that is named. Show computations. (CMA adapted) P8-6 (Dollar-Value LIFO) Falcon's Televisions produces television sets in three categories: portable, midsize, and console. On January 1, 2003, Falcon adopted dollar-value LIFO and decided to use a single inventory pool. The company's January 1 inventory consists of:
Portable Midsize Console
6,000 8,000 3,000 17,000
Cost per Unit
$100 250 400
$ 600,000 2,000,000 1,200,000 $3,800,000
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N Chapter 8 Accounting for Inventories During 2003, the company had the following purchases and sales.
Portable Midsize Console
15,000 20,000 10,000 45,000
Cost per Unit
$120 300 460
14,000 24,000 6,000 44,000
Selling Price per Unit
$150 405 600
(Round to four decimals.) (a) Compute ending inventory, cost of goods sold, and gross profit. (b) Assume the company uses three inventory pools instead of one. Repeat instruction (a).
P8-7 (LIFO Effect on Income) Michelle Kwan Inc. sells two products: figure skates and speed skates. At December 31, 2004, Kwan used the first-in, first-out (FIFO) inventory method. Effective January 1, 2005, Kwan changed to the last-in, first-out (LIFO) inventory method. The cumulative effect of this change is not determinable and, as a result, the ending inventory of 2004 for which the FIFO method was used is also the beginning inventory for 2005 for the LIFO method. Any layers added during 2005 should be costed by reference to the first acquisitions of 2005 and any layers liquidated during 2005 should be considered a permanent liquidation. The following information was available from Kwan's inventory records for the 2 most recent years.
Figure Skates Units 2004 purchases
January 7 April 16 November 8 December 13 7,000 12,000 17,000 9,000 $40.00 45.00 54.00 62.00 22,000 18,500 $20.00 34.00
Speed Skates Units Unit Cost
February 11 May 20 October 15 December 23 3,000 8,000 20,000 66.00 75.00 81.00 23,000 36.00
Units on hand
December 31, 2004 December 31, 2005 15,100 18,000 15,000 13,200
Compute the effect on income before income taxes for the year ended December 31, 2005, resulting from the change from the FIFO to the LIFO inventory method. (AICPA adapted)
P8-8 (Dollar-Value LIFO) Warren Dunn Company cans a variety of vegetable-type soups. Recently, the company decided to value its inventories using dollar-value LIFO pools. The clerk who accounts for inventories does not understand how to value the inventory pools using this new method, so, as a private consultant, you have been asked to teach him how this new method works. He has provided you with the following information about purchases made over a 6-year period.
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Ending Inventory (End-of-Year Prices)
$ 80,000 115,500 108,000 131,300 154,000 174,000
Dec. Dec. Dec. Dec. Dec. Dec. 31, 31, 31, 31, 31, 31, 1998 1999 2000 2001 2002 2003
100 105 120 130 140 145
You have already explained to him how this inventory method is maintained, but he would feel better about it if you were to leave him detailed instructions explaining how these calculations are done and why he needs to put all inventories at a base-year value.
(a) Compute the ending inventory for Warren Dunn Company for 1998 through 2003 using dollar-value LIFO. (b) Using your computation schedules as your illustration, write a step-by-step set of instructions explaining how the calculations are done. Begin your explanation by briefly explaining the theory behind this inventory method, including the purpose of putting all amounts into base-year price levels. P8-9 (Lower of Cost or Market) Grant Wood Company manufactures desks. Most of the company's desks are standard models and are sold on the basis of catalog prices. At December 31, 2004, the following finished desks appear in the company's inventory.
2004 catalog selling price FIFO cost per inventory list 12/31/04 Estimated current cost to manufacture (at December 31, 2004, and early 2005) Sales commissions and estimated other costs of disposal 2005 catalog selling price
$450 470 460 45 500
$480 450 440 60 540
$900 830 610 90 900
$1,050 960 1,000 130 1,200
The 2004 catalog was in effect through November 2004, and the 2005 catalog is effective as of December 1, 2004. All catalog prices are net of the usual discounts. Generally, the company attempts to obtain a 20% gross margin on selling price and has usually been successful in doing so.
At what amount should each of the four desks appear in the company's December 31, 2004, inventory, assuming that the company has adopted a lower of FIFO cost or market approach for valuation of inventories on an individual-item basis? P8-10 (Lower of Cost or Market) Jonathan Brandis Company is a food wholesaler that supplies independent grocery stores in the immediate region. The company has a perpetual inventory system for all of its food products. The first-in, first-out (FIFO) method of inventory valuation is used to determine the cost of the inventory at the end of each month. Transactions and other related information regarding two of the items (instant coffee and sugar) carried by Brandis are given below for October 2003, the last month of Brandis' fiscal year.
Standard unit of packaging Inventory, 10/1/03 Purchases Case containing 24, one-pound jars. 1,000 cases @ $60.20 per case 1. 10/10/03--1,600 cases @ $62.10 per case plus freight of $480. 2. 10/20/03--2,400 cases @ $64.00 per case plus freight of $480.
Baler containing 12, five-pound bags. 500 balers @ $6.50 per baler 1. 10/5/03--850 balers @ $5.76 per baler plus freight of $320. 2. 10/16/03--640 balers @ $6.00 per baler plus freight of $320. 3. 10/24/03--600 balers @ $6.20 per baler plus freight of $360.
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N Chapter 8 Accounting for Inventories
Purchase terms October sales Returns and allowances 2/10, net/30, f.o.b. shipping point 3,600 cases @ $76.00 per case A customer returned 50 cases that had been shipped in error. The customer's account was credited for $3,800. Net 30 days, f.o.b. shipping point 1,950 balers @ $8.00 per baler As the October 16 purchase was unloaded, 20 balers were discovered damaged. A representative of the trucking firm confirmed the damage and the balers were discarded. Credit of $120 for the merchandise and $10 for the freight was received by Brandis. $6.60 per baler $5.61 per baler
Inventory values 10/31/03 Net realizable value Net realizable value less a normal profit of 15% of net realizable value
$66.00 per case $56.10 per case
Brandis' sales terms are 1/10, net/30, f.o.b. shipping point. Brandis records all purchases net of purchase discounts and takes all purchase discounts. The most recent quoted price for coffee is $60 per case and for sugar $6.10 per baler, before freight and purchase discounts.
(a) Calculate the number of units in inventory and the FIFO unit cost for instant coffee and sugar as of October 31, 2003. (b) Brandis Company applies the lower of cost or market rule in valuing its year-end inventory. Calculate the total dollar amount of the inventory for instant coffee and sugar applying the lower of cost or market rule on an individual-product basis. (c) Could Brandis Company apply the lower of cost or market rule to groups of products or the inventory as a whole rather than on an individual-product basis? Explain your answer. (CMA adapted) P8-11 (Statement and Note Disclosure, and LCM) Garth Brooks Specialty Company, a division of Fresh Horses Inc., manufactures three models of gear shift components for bicycles that are sold to bicycle manufacturers, retailers, and catalog outlets. Since beginning operations in 1971, Brooks has assumed a first-in, first-out cost flow in its perpetual inventory system. Except for overhead, manufacturing costs are accumulated using actual costs. Overhead is applied to production using predetermined overhead rates. The balances of the inventory accounts at the end of Brooks's fiscal year, November 30, 2003, are shown below. The inventories are stated at cost before any year-end adjustments.
Finished goods Work-in-process Raw materials Factory supplies $647,000 112,500 240,000 69,000
The following information relates to Brooks' inventory and operations. 1. The finished goods inventory consists of the items analyzed below.
Cost Down tube shifter
Standard model Click adjustment model Deluxe model Total down tube shifters $ 67,500 94,500 108,000 270,000
$ 67,000 87,000 110,000 264,000
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Conceptual Cases N
Bar end shifter
Standard model Click adjustment model Total bar end shifters 83,000 99,000 182,000 90,050 97,550 187,600
Head tube shifter
Standard model Click adjustment model Total head tube shifters Total finished goods 78,000 117,000 195,000 $647,000 77,650 119,300 196,950 $648,550
2. 3. 4. 5. 6. 7.
One-half of the head tube shifter finished goods inventory is held by catalog outlets on consignment. Three-quarters of the bar end shifter finished goods inventory has been pledged as collateral for a bank loan. One-half of the raw materials balance represents derailleurs acquired at a contracted price 20 percent above the current market price. The market value of the rest of the raw materials is $127,400. The total market value of the work-in-process inventory is $108,700. Included in the cost of factory supplies are obsolete items with an historical cost of $4,200. The market value of the remaining factory supplies is $65,900. Brooks applies the lower of cost or market method to each of the three types of shifters in finished goods inventory. For each of the other three inventory accounts, Brooks applies the lower of cost or market method to the total of each inventory account. Consider all amounts presented above to be material in relation to Brooks' financial statements taken as a whole.
(a) Prepare the inventory section of Brooks's statement of financial position as of November 30, 2003, including any required note(s). (b) Without prejudice to your answer to requirement (a), assume that the market value of Brooks's inventories is less than cost. Explain how this decline would be presented in Brooks's income statement for the fiscal year ended November 30, 2003. (CMA adapted) *P8-12 (Gross Profit Method) David Hasselholf Company lost most of its inventory in a fire in December just before the year-end physical inventory was taken. Corporate records disclose the following.
Inventory (beginning) Purchases Purchase returns $ 80,000 280,000 28,000 Sales Sales returns Gross profit % based on selling price $415,000 21,000 34%
Merchandise with a selling price of $30,000 remained undamaged after the fire, and damaged merchandise has a salvage value of $7,150. The company does not carry fire insurance on its inventory.
Prepare a formal labeled schedule computing the fire loss incurred, using the gross profit method.
C8-1 (Inventoriable Costs) You are asked to travel to Milwaukee to observe and verify the inventory of the Milwaukee branch of one of your clients. You arrive on Thursday, December 30, and find that the inventory procedures have just been started. You spot a railway car on the sidetrack at the unloading door and ask the warehouse superintendent Predrag Danilovic how he plans to inventory the contents of the car. He responds, "We are not going to include the contents in the inventory."
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N Chapter 8 Accounting for Inventories Later in the day, you ask the bookkeeper for the invoice on the carload and the related freight bill. The invoice lists the various items, prices, and extensions of the goods in the car. You note that the carload was shipped December 24 from Albuquerque, f.o.b. Albuquerque, and that the total invoice price of the goods in the car was $35,300. The freight bill called for a payment of $1,500. Terms were net 30 days. The bookkeeper affirms the fact that this invoice is to be held for recording in January.
(a) Does your client have a liability that should be recorded at December 31? Discuss. (b) Prepare a journal entry(ies), if required, to reflect any accounting adjustment required. Assume a perpetual inventory system is used by your client. (c) For what possible reason(s) might your client wish to postpone recording the transaction?
C8-2 (Inventoriable Costs) Alonzo Spellman, an inventory control specialist, is interested in better understanding the accounting for inventories. Although Alonzo understands the more sophisticated computer inventory control systems, he has little knowledge of how inventory cost is determined. In studying the records of Ditka Enterprises, which sells normal brand-name goods from its own store and on consignment through Wannstedt Inc., he asks you to answer the following questions.
(a) Should Ditka Enterprises include in its inventory normal brand-name goods purchased from its suppliers but not yet received if the terms of purchase are f.o.b. shipping point (manufacturer's plant)? Why? (b) Should Ditka Enterprises include freight-in expenditures as an inventory cost? Why? (c) What are products on consignment? How should they be reported in the financial statements? (AICPA adapted)
C8-3 (Inventoriable Costs) Jack McDowell, the controller for McDowell Lumber Company, has recently hired you as assistant controller. He wishes to determine your expertise in the area of inventory accounting and therefore asks you to answer the following unrelated questions. (a) A company is involved in the wholesaling and retailing of automobile tires for foreign cars. Most of the inventory is imported, and it is valued on the company's records at the actual inventory cost plus freightin. At year-end, the warehousing costs are prorated over cost of goods sold and ending inventory. Are warehousing costs considered a product cost or a period cost? (b) A certain portion of a company's "inventory" is composed of obsolete items. Should obsolete items that are not currently consumed in the production of "goods or services to be available for sale" be classified as part of inventory? (c) A company purchases airplanes for sale to others. However, until they are sold, the company charters and services the planes. What is the proper way to report these airplanes in the company's financial statements?
C8-4 (General Inventory Issues) In January 2004, Wesley Crusher Inc. requested and secured permission from the commissioner of the Internal Revenue Service to compute inventories under the last-in, first-out (LIFO) method and elected to determine inventory cost under the dollar-value method. Crusher Inc. satisfied the commissioner that cost could be accurately determined by use of an index number computed from a representative sample selected from the company's single inventory pool.
(a) Why should inventories be included in (1) a balance sheet and (2) the computation of net income? (b) The Internal Revenue Code allows some accountable events to be considered differently for income tax reporting purposes and financial accounting purposes, while other accountable events must be reported the same for both purposes. Discuss why it might be desirable to report some accountable events differently for financial accounting purposes than for income tax reporting purposes.
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(c) Discuss the ways and conditions under which the FIFO and LIFO inventory costing methods produce different inventory valuations. Do not discuss procedures for computing inventory cost. (AICPA adapted) C8-5 (LIFO Inventory Advantages) Jean Honore, president of Fragonard Co., recently read an article that claimed that at least 100 of the country's largest 500 companies were either adopting or considering adopting the last-in, first-out (LIFO) method for valuing inventories. The article stated that the firms were switching to LIFO to (1) neutralize the effect of inflation in their financial statements, (2) eliminate inventory profits, and (3) reduce income taxes. Ms. Honore wonders if the switch would benefit her company. Fragonard currently uses the first-in, first-out (FIFO) method of inventory valuation in its periodic inventory system. The company has a high inventory turnover rate, and inventories represent a significant proportion of the assets. Ms. Honore has been told that the LIFO system is more costly to operate and will provide little benefit to companies with high turnover. She intends to use the inventory method that is best for the company in the long run rather than selecting a method just because it is the current fad.
(a) Explain to Ms. Honore what "inventory profits" are and how the LIFO method of inventory valuation could reduce them. (b) Explain to Ms. Honore the conditions that must exist for Fragonard Co. to receive tax benefits from a switch to the LIFO method.
C8-6 (Average Cost, FIFO, and LIFO) Prepare a memorandum containing responses to the following items. (a) Describe the cost flow assumptions used in average cost, FIFO, and LIFO methods of inventory valuation. (b) Distinguish between weighted average cost and moving average cost for inventory costing purposes. (c) Identify the effects on both the balance sheet and the income statement of using the LIFO method instead of the FIFO method for inventory costing purposes over a substantial time period when purchase prices of inventoriable items are rising. State why these effects take place.
C8-7 (LIFO Application and Advantages) Neshki Corporation is a medium-sized manufacturing company with two divisions and three subsidiaries, all located in the United States. The Metallic Division manufactures metal castings for the automotive industry, and the Plastics Division produces small plastic items for electrical products and other uses. The three subsidiaries manufacture various products for other industrial users. Neshki Corporation plans to change from the lower of first-in, first-out (FIFO) cost or market method of inventory valuation to the last-in, first-out (LIFO) method of inventory valuation to obtain tax benefits. To make the method acceptable for tax purposes, the change also will be made for its annual financial statements.
(a) Describe the establishment of and subsequent pricing procedures for each of the following LIFO inventory methods. (1) LIFO applied to units of product when the periodic inventory system is used. (2) Application of the dollar-value method to LIFO units of product. (b) Discuss the specific advantages and disadvantages of using the dollar-value LIFO application as compared to specific goods LIFO (unit LIFO). Ignore income tax considerations. (c) Discuss the general advantages and disadvantages claimed for LIFO methods.
C8-8 (Dollar-Value LIFO Issues) Maria Callas Co. is considering switching from the specific goods LIFO approach to the dollar-value LIFO approach. Because the financial personnel at Callas know very little about dollar-value LIFO, they ask you to answer the following questions.
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N Chapter 8 Accounting for Inventories (a) (b) (c) (d) (e) What is a LIFO pool? Is it possible to use a LIFO pool concept and not use dollar-value LIFO? Explain. What is a LIFO liquidation? How are price indexes used in the dollar-value LIFO method? What are the advantages of dollar-value LIFO over specific goods LIFO?
C8-9 (FIFO and LIFO) Günter Grass Company is considering changing its inventory valuation method from FIFO to LIFO because of the potential tax savings. However, the management wishes to consider all of the effects on the company, including its reported performance, before making the final decision. The inventory account, currently valued on the FIFO basis, consists of 1,000,000 units at $7 per unit on January 1, 2004. There are 1,000,000 shares of common stock outstanding as of January 1, 2004, and the cash balance is $400,000. The company has made the following forecasts for the period 20042006.
Unit sales (in millions of units) Sales price per unit Unit purchases (in millions of units) Purchase price per unit Annual depreciation (in thousands of dollars) Cash dividends per share Cash payments for additions to and replacement of plant and equipment (in thousands of dollars) Income tax rate Operating expense (exclusive of depreciation) as a percent of sales Common shares outstanding (in millions) 1.1 $10 1.0 $7 $300 $0.15 $350 40% 15% 1
1.0 $10 1.1 $8 $300 $0.15 $350 40% 15% 1
1.3 $12 1.2 $9 $300 $0.15 $350 40% 15% 1
(a) Prepare a schedule that illustrates and compares the following data for Günter Grass Company under the FIFO and the LIFO inventory method for 20042006. Assume the company would begin LIFO at the beginning of 2004. (1) Year-end inventory balances. (2) Annual net income after taxes. (3) Earnings per share. (4) Cash balance. Assume all sales are collected in the year of sale and all purchases, operating expenses, and taxes are paid during the year incurred. (b) Using the data above, your answer to (a), and any additional issues you believe need to be considered, prepare a report that recommends whether or not Günter Grass Company should change to the LIFO inventory method. Support your conclusions with appropriate arguments. (CMA adapted) C8-10 (Lower of Cost or Market) You have been asked by the financial vice president to develop a short presentation on the lower of cost or market method for inventory purposes. The financial VP needs to explain this method to the president, because it appears that a portion of the company's inventory has declined in value.
The financial VP asks you to answer the following questions. (a) What is the purpose of the lower of cost or market method? (b) What is meant by market? (Hint: Discuss the ceiling and floor constraints.) (c) Do you apply the lower of cost or market method to each individual item, to a category, or to the total of the inventory? Explain. (d) What are the potential disadvantages of the lower of cost or market method?
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C8-11 (LIFO Method) Gamble Company uses the LIFO method for inventory costing. In an effort to lower net income, company president Oscar Gamble tells the plant accountant to take the unusual step of recommending to the purchasing department a large purchase of inventory at year-end. The price of the item to be purchased has nearly doubled during the year, and the item represents a major portion of inventory value.
Answer the following questions. (a) Identify the major stakeholders. If the plant accountant recommends the purchase, what are the consequences? (b) If Gamble Company were using the FIFO method of inventory costing, would Oscar Gamble give the same order? Why or why not? *C8-12 (Gross Profit Method) Presented below is information related to Joey Harrington Corporation for the current year.
Beginning inventory Purchases Total goods available for sale Sales $ 600,000 1,500,000 $2,100,000 2,500,000
(a) Compute the ending inventory, assuming that (1) gross profit is 45% of sales; (2) gross profit is 60% of cost; (3) gross profit is 35% of sales; and (4) gross profit is 25% of cost. (b) Harrington would like to use the gross profit method to value its inventories for financial reporting purposes. Prepare a brief memorandum to Harrington explaining why use of the gross profit method would not be permitted for financial reporting.
Using Your Judgment
Financial Reporting Problem
The financial statements of 3M were provided with your book or can be accessed on the Take Action! CD.
Refer to 3M's financial statements and the accompanying notes to answer the following questions. (a) How does 3M value its inventories? Which inventory costing method does 3M use as a basis for reporting its inventories? (b) How does 3M report its inventories in the balance sheet? In the notes to its financial statements, what three descriptions are used to classify its inventories? (c) What was 3M's inventory turnover ratio in 2001? What is its gross profit percentage? Evaluate 3M's inventory turnover ratio and gross profit percentage.
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Financial Statement Analysis Cases
Case 1 Sonic, Inc.
Sonic, Inc. reported the following information regarding 20012002 inventory.
Current assets Cash Accounts receivable, net of allowance for doubtful accounts of $46,000 in 2002 and $160,000 in 2001 Inventories (Note 2) Other current assets Assets of discontinued operations Total current assets $ 153,010 1,627,980 1,340,494 123,388 -- 3,244,872 Notes to Consolidated Financial Statements Note 1 (in part): Nature of Business and Significant Accounting Policies
$ 538,489 2,596,291 1,734,873 90,592 32,815 4,993,060
Inventories --Inventories are stated at the lower of cost or market. Cost is determined by the last-in, first-out (LIFO) method by the parent company and by the first-in, first-out (FIFO) method by its subsidiaries. Note 2: Inventories Inventories consist of the following:
Raw materials Work in process Finished goods and display units Total inventories Less: Amount classified as long-term Current portion $1,264,646 240,988 129,406 1,635,040 294,546 $1,340,494
$2,321,178 171,222 711,252 3,203,652 1,468,779 $1,734,873
Inventories are stated at the lower of cost determined by the LIFO method or market for Sonic, Inc. Inventories for the two wholly-owned subsidiaries, Sonic Command, Inc. (U.S.) and Sonic Limited (U.K.) are stated on the FIFO method which amounted to $566,000 at October 31, 2001. No inventory is stated on the FIFO method at October 31, 2002. Included in inventory stated at FIFO cost was $32,815 at October 31, 2001, of Sonic Command inventory classified as an asset from discontinued operations (see Note 14). If the FIFO method had been used for the entire consolidated group, inventories after an adjustment to the lower of cost or market, would have been approximately $2,000,000 and $3,800,000 at October 31, 2002 and 2001, respectively. Inventory has been written down to estimated net realizable value, and results of operations for 2002, 2001, and 2000 include a corresponding charge of approximately $868,000, $960,000, and $273,000, respectively, which represents the excess of LIFO cost over market. Inventory of $294,546 and $1,468,779 at October 31, 2002 and 2001, respectively, shown on the balance sheet as a noncurrent asset represents that portion of the inventory that is not expected to be sold currently. Reduction in inventory quantities during the years ended October 31, 2002, 2001, and 2000 resulted in liquidation of LIFO inventory quantities carried at a lower cost prevailing in prior years as compared with the cost of fiscal 2000 purchases. The effect of these reductions was to decrease the net loss by approximately $24,000, $157,000 and $90,000 at October 31, 2002, 2001, and 2000, respectively.
(a) Why might Sonic, Inc. use two different methods for valuing inventory? (b) Comment on why Sonic, Inc. might disclose how its LIFO inventories would be valued under FIFO.
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(c) Why does the LIFO liquidation reduce operating costs? (d) Comment on whether Sonic would report more or less income if it had been on a FIFO basis for all its inventory.
Case 2 Barrick Gold Corporation
Barrick Gold Corporation, with headquarters in Toronto, Canada, is the world's most profitable and largest gold mining company outside South Africa. Part of the key to Barrick's success has been due to its ability to maintain cash flow while improving production and increasing its reserves of gold-containing property. During 2000, Barrick achieved record growth in cash flow, production, and reserves. The company maintains an aggressive policy of developing previously identified target areas that have the possibility of a large amount of gold ore, and that have not been previously developed. Barrick limits the riskiness of this development by choosing only properties that are located in politically stable regions, and by the company's use of internally generated funds, rather than debt, to finance growth. Barrick's inventories are as follows:
Inventories (in millions, US dollars)
Current Gold in process Mine operating supplies Non-current (included in property, plant, and equipment) Ore in stockpiles $ 85 43 $128
(a) Why do you think that there are no finished goods inventories? Why do you think the raw material, ore in stockpiles, is considered to be a non-current asset? (b) Consider that Barrick has no finished goods inventories. What journal entries are made to record a sale? (c) Suppose that gold bullion that cost $1.8 million to produce was sold for $2.4 million. The journal entry was made to record the sale, but no entry was made to remove the gold from the gold in process inventory. How would this error affect the following?
Inventory Retained earnings Accounts payable Working capital Current ratio ? ? ? ? ?
Cost of goods sold Net income ? ?
Comparative Analysis Case
The Coca-Cola Company and PepsiCo, Inc.
Go to the Take Action! CD and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) What is the amount of inventory reported by Coca-Cola at December 31, 2001, and by PepsiCo at December 31, 2001? What percent of total assets is invested in inventory by each company? (b) What inventory costing methods are used by Coca-Cola and PepsiCo? How does each company value its inventories?
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N Chapter 8 Accounting for Inventories (c) In the notes, what classifications (description) are used by Coca-Cola and PepsiCo to categorize their inventories? (d) Compute and compare the inventory turnover ratios and days to sell inventory for 2001 for Coca-Cola and PepsiCo. Indicate why there might be a significant difference between the two companies.
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Remember to check the Take Action! CD and the book's companion Web site to find additional resources for this chapter.
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